Crossover – Breaking the Ratings Barrier – September 2017

Incorporating high yield credits into an investment grade portfolio can enhance yield without increasing volatility.

Investors are struggling with the low yields available from investment grade debt, both in the corporate and sovereign segments of the market (Fig. 1).

For those with a more flexible mandate looking for additional yield, investors may consider an allocation to a crossover strategy. As the name suggests, crossover straddles the line between the defined ratings buckets of investment grade and high yield.

Fig. 1 – Yields on Core Government Fixed Income Are Low

Source: Bloomberg, as at August 17th 2017.

 

Enhancing Yield

In our view, combining high yield and investment grade rated credits into a single portfolio can significantly enhance yield and generate higher returns over the course of the credit cycle, while mitigating volatility (Figs. 2, 3 & 4).

However, with the greater risk associated with high yield debt, we believe investors should carry out thorough credit analysis and maintain a deep focus on the cash-flow-generative nature of the issuer to ensure a company is able to honour its debt obligations and avoid default. Avoidance of speculative investments is paramount.

Fig. 2 – Higher Yields

Source: BofA Merrill Lynch, Bloomberg, Muzinich & Co. as of 18th July 2017.

 

Fig. 3 – Historical 7-year Risk and Return in Crossover Bonds

Source: Bloomberg & BofA Merrill Lynch. Data as of June 30th, 2017. Crossover Index includes 70% of the Euro Corp BBB (ER40) and 30% of the Euro Corp BB (HE10). The Euro investment grade (ER00), Euro high yield (HP00), German Fed government 1-10yr index (G2D0), German Fed government 3-5yr index (G2D0) and the Deutsche Boerse AG German Stock Index (DAX). The Duration to Worst of all the indices average around 4.2%. Past performance is not indicative of future returns.

 

Fig. 4 – Higher Return than Investment Grade but Similar Volatility

Source: Muzinich & Co, Bloomberg, BofA Merrill Lynch, as of July 31st 2017. Past performance is not indicative of future returns. Representative Crossover strategy is the Muzinich Enhancedyield Short-Term Fund. Launched on 26 November 2003.

 

Crossover Benefits

Within high yield, the length of time for which an investor holds a bond is an important factor in extracting additional yield. By holding a callable high yield bond until its call date, an investor can benefit from the running yield, which is much higher in value than the yield-to-worst, and provides a hidden source of return.

Within bullet bonds, an investor can also capture the ‘roll down’, which is another source of hidden return and is the price evolution of a bond as time passes. The roll down contributes to the total return and is generated when a bond is purchased (in an upward sloping yield curve environment). As the bond rolls down the curve (for example when a three-year bond becomes a two-year bond), the roll down contributes to the bond’s total return which can make the contribution higher than the return implied by the annualised yield over the lifetime of a bond.

Lower Correlation

With the potential for rates to begin rising on both sides of the Atlantic, a crossover strategy can also provide protection from duration risk; high yield credits are less sensitive to interest rate rises and thus have a very low correlation to both government bonds and investment grade credit. Therefore, incorporating high yield into an investment grade portfolio can act as a great diversifier in a rising rate environment.

A Large Investible Universe

The crossover universe has grown considerably over the last 10 years (Fig. 5). B and BB rated corporates numbered 2364 in 2007, yet today there are nearly 4000. The story is more pronounced in the BBB space which has risen from 2265 issues to over 6000.* This offers investors a large, well-diversified opportunity set in terms of sector, region and rating.

However, in such a large universe how does an asset manager select the best credits in order to generate attractive risk-adjusted returns?

Fig. 5 – Sizeable Opportunity Set

Source: Source: BofA Merrill Lynch, Bloomberg, as of July 31st 2017. GI00 – BofA Merrill Lynch Global Corporate Broad Corporate & High Yield Index.

 

We believe there are two key elements to managing a successful crossover strategy: credit selection and asset allocation.

Credit Selection

In our view, credit selection is paramount to ensuring successful performance generation; an investor needs to understand the characteristics of the investment instruments in order to extract the most value.

While fundamental analysis and bottom-up research is an obvious requirement in high yield, we believe it is equally important in investment grade.

Screening out the lowest-yielding segment of the market – the sizable, over-bought, well-known names and those under the European Central Bank’s (ECB) asset purchase programme – can lead to a higher average yield on the rest of the universe. We believe the less well-recognised credits can offer a more attractive risk/return perspective.

In addition, for investors who have greater flexibility in their mandates and the available resources, there is the opportunity to further expand their opportunity set by looking at mis-rated or unrated credits.

In some instances, smaller companies may not have a rating because they may be unable to pay the costs associated with obtaining a credit rating, while also being too small for index inclusion.
These opportunities can fall under the radar of investors who lack the dedicated resources to make their own assessments of individual company fundamentals.

Asset Allocation

An asset allocation component is also an essential part of a successful crossover strategy. In a global universe, investors must look across the US, emerging and European markets in both the investment grade and high yield space (including loans if permitted) to determine the most optimal allocation by region and sub-asset class.

The ability to change the size of an investment grade or high yield allocation can ensure the portfolio is well positioned in a rising or falling interest rate environment. A declining economic backdrop or poor sentiment benefits investment grade as rates rally. The reverse is true in high yield where an allocation in an environment of improving economic fundamentals helps offset higher rates.

Conclusion

We appear to be over the worst of the financial crisis and global central bank rhetoric is turning increasingly hawkish. Tighter monetary policy and higher rates are likely to have an impact on all fixed income assets, sovereign and corporate, and the outlook appears uncertain.

Following a benign and bullish period for credit that has proven a boon to passive investors, we are entering a new era that we believe should play to the strengths of an active manager.

In our view, an investor who has the resources and expertise to carry out in-depth credit analysis on all the bonds in their portfolio, and who are unconstrained by ratings allocations, is likely to be able to provide better risk-adjusted returns in their portfolios as well as protection to the downside, in all market conditions.

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Important Information

This document has been produced for information purposes only and as such the views contained herein are not to be taken as investment advice. Opinions are as of date of publication and are subject to change without reference or notification to you. Past results do not guarantee future performance. The value of investments and the income from them may fall as well as rise and is not guaranteed and investors may not get back the full amount invested.

Any research in this document has been procured and may have been acted on by Muzinich for its own purpose. The results of such research are being made available for information purposes and do not constitute investment advice. Opinions and statements of financial market trends that are based on market conditions constitute our judgement as at the date of this document. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted.

Emerging Markets may be more risky than more developed markets for a variety of reasons, including but not limited to, increased political, social and economic instability; heightened pricing volatility and reduced market liquidity.

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