BB credit: A sweet spot?

BB credit: A sweet spot? In a low-yielding environment, how can institutional investors best achieve adequate returns on fixed income? Ty Anderson Global Head of High Yield Strategies evaluates how credit quality can be used most effectively to drive performance in a potentially bumpy recovery In this article we examine credit quality as a driver of fixed income performance, analyzing the trade-off between return and risk along the rating scale. We make two key points: We believe investment grade portfolios may benefit in all market environments from the addition of BB rated bonds, since they can offer relatively attractive returns and tend to be more stable than the high yield universe overall. We show that over medium and longer time horizons, BBs have achieved approximately equivalent or better returns than the high yield universe overall, but with lower credit risk. We argue that this makes BBs potentially attractive all-weather investments; the broader high yield universe still offers sound opportunities, but in our view on a tactical rather than strategic basis. Challenging times Investors have understandably welcomed a return to economic growth, but the new environment has brought fresh challenges for institutions needing to achieve adequate returns while controlling risk. For one thing, the 2008 financial crisis did nothing to restore faith in equities as a reliable driver of long-term portfolio growth, while also revealing significant liquidity risk in some alternative asset classes. In contrast, fixed income s relative stability and better riskadjusted returns have helped to enhance the standing of this oldest of institutional asset classes. But with interest rates low worldwide and investment-grade credit spreads approaching pre-recession tights, how should fixed income allocations be structured to generate adequate returns for institutional investors? Which risk dials should be turned up to achieve sufficient return without incurring unacceptable downside risks? Fixed income risk dials There are many ways to dial risk up or down within a fixed income portfolio. Generally, the broader the investment universe, the more dials there are. For example, an active global bond portfolio can exploit geographic and currency risks that are not available to a domestic fixed income investor. Leverage either on a cash basis or synthetically is another risk dial, although one that yielded decidedly mixed results for many in the recent cycle. Which risk dials should be turned up without incurring unacceptable downside risks? At the most basic level, the two key drivers of fixed income risk and return are duration and credit risk. First, duration. In normal markets including today s investors earn a higher current yield for owning longer bonds. But generating adequate returns from the duration risk dial may not prove straightforward: it is hard to think of long-term rates declining from today s

historically low levels, which may constrain the upside. On the other hand, a rate increase (resulting from, say, investors fear of government spending competing with recovering private economic activity) would obviously be bad news for investors on the long end of the curve. Of course, staying shorter on the curve would limit this risk, but today s very low short term rates are unlikely to meet the return requirements of many institutional investors. Risk-adjusted returns (Sharpe ratios) Treasuries, investment grade, high yield On a risk-adjusted basis, as measured by Sharpe ratio, the case for dialing up credit risk looks still more doubtful: over some periods high yield outperformed on a risk-adjusted basis, but at other times it lagged. 1.00 The case for credit risk So what of credit risk? Bonds that carry greater credit risk usually offer higher yield, but total return is influenced by additional factors such as defaults and realized losses over time. As with other drivers of return, sometimes investors are well rewarded for taking credit risk, other times not. Below, we examine returns (and riskadjusted returns) along the credit spectrum. Annualized fixed income returns Treasuries, investment grade, high yield, equity The chart below shows 3, 5 and 10 year total returns across the fixed income credit spectrum a sufficient period to see past the distortions of the whip-saw years of 2008 and 2009. Equities are included as a reference. Over most periods investors gained a slight return pick-up for taking additional credit risk, but not all. - - - 10yr Treasury 5.97% 4.23% 6.1 IG 5.31% 4.45% 6.57% HY 5.8 6.35% 6.5 Equity -5.31% 0.4-0.91% 0.75 0.50 0.25 0.00 10yr Treasury 0.42 0.17 0.40 IG 0.37 0.22 0.60 HY 0.22 0.26 0.33 All high yield is not equal If we separate out up-in-credit high yield bonds (that is, BBs) and compare them with higher rated fixed income, the effectiveness of the credit risk dial becomes clearer. Annualized fixed income returns Treasuries, investment grade, BBs only Comparing BBs only with treasuries and investment grade credit, in every period investors were rewarded with a higher annualized return for taking more credit risk. 7% 5% 3% 1% 10yr Treasury 5.97% 4.23% 6.1 IG 5.31% 4.45% 6.57% BB 6.2 6.33% 6.91%

Risk-adjusted returns (Sharpe ratios) Treasuries, investment grade, BBs only The cost of additional return is volatility: BB bonds are somewhat more volatile than either treasuries or investment grade bonds in each period, which is why they did not always deliver the best risk-adjusted return. One other notable feature of this chart is that the risk-adjusted returns of BB bonds were the most consistent of the asset classes shown. 1.00 0.75 0.50 0.25 0.00 10yr Treasury 0.42 0.17 0.40 IG 0.37 0.22 0.60 BB 0.31 0.32 0.44 The data shown above suggests that BBs behave differently to the rest of the high yield sector. In the following charts, we split out BBs and compare their performance to the high yield universe overall. Annualized fixed income returns BBs, high yield overall Perhaps surprisingly since BB bonds have stronger credit ratings the total return from BBs approximately equaled or bettered the broader index in all periods. 7% 5% 3% 1% HY 5.8 6.35% 6.5 BB 6.2 6.33% 6.91% Risk-adjusted returns (Sharpe ratios) BBs, high yield overall As this chart shows, BBs achieved better average risk-adjusted returns over all periods. 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 HY 0.22 0.26 0.33 BB 0.31 0.32 0.44 Reasons for strong returns of BB credit To summarize: the evidence above seems to suggest that, over the medium term, the credit risk/return trade-off breaks down at the BB rating level, and that BBs tend to behave somewhat differently to the rest of the high yield universe. Is the observation due to a quirk in the numbers, or could there be a rational basis for it? We think there are good reasons why mediumterm returns may peak at the BB rating level, and also why BBs can offer particularly attractive opportunities to active investors. These include: BB returns are more stable over time than lower-rated credit Default levels for BB bonds show less variation than high yield overall The natural level of demand for BB bonds is somewhat restricted, which creates opportunities for investors The fact that BB is on the borderline between investment-grade and speculative debt may also assist BBs outperform lower rated credit We explore these reasons in more detail below.

Stability of returns As recent market moves demonstrate, bonds rated below BB can generate substantial returns, at least over shorter time horizons. In 2009, when risk appetite returned, CCC rated high yield returned a stunning 9, against 57% for the broad high yield index and 45% for BBs. Lower-rated credit often excels in transitional markets like 2009, which are typically characterized by larger swings, because it is much more sensitive to market timing and technical momentum than BB credit. For the same reasons, over full cycles lower-rated credit tends to do less well, particularly on a riskadjusted basis. Stability of defaults Below-investment grade credits on average default much more frequently than investmentgrade bonds. According to Moody s, the average annual default rate over the 10 years ending 2009 was 0.23% for investment grade but 3. for high yield. Within high yield, the annual average BB default rate was 2.1%. But BB default rates are not only (not surprisingly) lower than the average for high yield; they are also much more stable over long periods. The 3, 5, and 20 year annualized default rates for BBs are 2.1%, 2.3%, and 1.9%, respectively, which is roughly equal to the rate of variability of investment-grade defaults. Broad high yield defaults are much more variable. In our view, the relative stability of credit event risk in the BB rating band helps support higher risk-adjusted returns over time in the up-in-credit part of the high yield universe. Smaller buying community BB bonds naturally have a constrained buying community. Investment grade managers are usually prohibited from buying BB bonds, or at least limited in their ability to buy them. Meanwhile, high yield investors often focus on current yield, on which basis BB bonds look relatively less attractive than the broad high yield index. We think these demand constraints can create entry prices that lead to stronger returns when the underlying performance of an issuer becomes apparent. Fallen angel effect Since the investment grade market is much larger than the high yield market, so-called fallen angels bonds that slip out of the investmentgrade space almost invariably have more sellers than buyers. As a result, bond prices often overshoot on the downside, creating opportunity for investors. Of course, fallen angels with fundamental operating problems do not always stop at BB, so capturing the opportunity requires sound fundamental credit research. Down-in-credit high yield offers investors opportunities, but more on a tactical than a strategic basis Rising star impact The fallen angel effect can work in reverse, also disproportionately favoring BB bondholders. A credit moving up to investment grade sees significant buying pressure, boosting prices. The issuer s management team has a strong incentive to cross over to investment grade from BB, since a BBB rating lowers the firm s cost of funds and improves capital market access. Single-B issuers in general are more apt to remain in the high yield market, often having made a strategic decision based on the benefits of financial leverage. Capturing the BB opportunity The quantitative evidence presented above highlights the strong performance of BB rated bonds relative to fixed income with either lower or higher credit risk both on a nominal and a risk-adjusted basis. We have also identified a number of qualitative factors that may help explain why. How should investors act on these observations? Is the optimal fixed income

portfolio 10 BB rated bonds? Should no one invest in the broader high yield market? Our answer to these questions is unequivocally no. In certain investment environments, such as the early stages of economic recovery, credit risk can pay handsomely and the broad high yield index (and especially down-in-credit high yield) will likely outperform. We therefore see down-incredit high yield as an important opportunity for investors, but more on a tactical than a strategic basis. Looking up the rating scale, although BB credit generally outperforms better rated fixed income, it does so at the cost of increased volatility, as the following chart shows. For these reasons, a 10 BB allocation is clearly not optimal. Standard deviation of returns Treasuries, investment grade, BBs efficient frontier of such a strategy, highlighting the advantage of a portfolio that includes a blend of credit quality. Efficient frontier Investment grade vs BBs (Jan 1997 to Dec 2009) Return 1 9% 7% 10 inv grade 5% 5% 7% 9% Risk 10 high yield 1 1 1 1 10yr Treasury 9.5 8.0 8.0 IG 8.9 7.2 6.2 BB 13.8 10.9 9.2 The significant opportunity for investors arises from the fact that the returns and volatilities of these segments have different shapes. The correlation between BB credit and 10-year treasuries tends to be slightly negative, while the correlation between BBs and investment grade credit has generally been around 0.75 over the medium term. Given this, adding BB credit risk to an investment-grade portfolio should reduce volatility relative to a pure investment-grade portfolio, while adding significant yield and total return potential. The following chart shows the Conclusions Credit quality is one of the key risk dials for fixed income investors. However, the evidence presented here suggests that cranking up the credit risk dial does not yield incremental performance benefits indefinitely, particularly on a risk-adjusted basis. In our view, up-in-credit high yield can offer a performance advantage over bonds of other rating levels over a medium-term horizon. For this reason, BB bonds may represent an attractive opportunity for investors with a wide variety of risk appetites, and can also play a useful role within a broader fixed income allocation. However, we would stress that the BB rating band is far from homogeneous. As active investors, we believe that extensive fundamental credit research is essential in making successful use of credit quality as a driver of portfolio performance. Ty Anderson is a Managing Director at DB Advisors and Global Head of High Yield Strategies

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