Many investors seeking yield in the current low interest rate environment are reluctant to take on high risk. Corporate crossover bonds, which straddle the line between the investment grade and high yield bond markets, may offer
a solution.

Q: What are corporate crossover bonds?
A: Crossover bonds are corporate bonds that, as a group, have higher yields than most investment grade bonds, yet less credit risk than the broad high yield market: This specific cohort of the corporate bond universe “crosses” the proverbial line that separates the high grade and high yield bond markets (because it includes components of both). This segment of the corporate market is a combination of the lowest level of investment grade (triple-B-plus through triple-B- minus ratings) and the highest level of high yield (double-B-plus through double-B-minus ratings).

At its core, a crossover strategy is generally thought of as a triple-B/double-B blend – either by way of a 50/50 split or market-capitalization weighting – but it can take other forms, such as targeting rising stars, or improving credits, that are likely to be upgraded from high yield to investment grade. While conceptually this may seem like a small cohort of the overall corporate universe, in aggregate, triple-B and double-B rated corporate bonds have experienced very strong and steady growth, and today total approximately $3 trillion from over 4,400 issuers, according to BofA Merrill Lynch (Figure 1.)

Contributing to their growth is increasing issuance from triple-B and double-B rated issuers in general, which today makes up over 35% of the total corporate primary market (Figure 2). With strong demand in addition to the robust growth in issuance since the financial crisis, crossover bonds now make up nearly half of the outstanding volume in the corporate bond market. Furthermore, triple- and double-B bond trading volume is about double that of either the investment grade or high yield market alone. In a market concerned more and more about liquidity, this is where some of the largest and more liquid deals reside.

Q: What are the primary benefits of crossover bonds?
A: While crossover bonds are not new, investing in the crossover segment as a strategy is gaining popularity, especially among investors with a keen focus on risk-adjusted returns. This is because crossover corporate bonds have a long history of providing high yield-like returns with high grade-like volatility. Since the late 1980s, crossover bonds have performed in line with the high yield market with about two-thirds of the volatility. Over the same time period, crossover bonds have outperformed investment grade credit both on an absolute and risk-adjusted basis (Figure 3).

What’s more, crossover bonds have a low correlation to U.S. Treasuries, as shown in Figure 4, an issue which is top-of-mind for many investors anticipating interest rate hikes from the Federal Reserve. While this correlation to Treasuries is higher than that for high yield bonds, nonetheless it is less than half of that for investment grade bonds. At the same time crossover bonds have achieved higher risk adjusted returns compared to investment grade bonds.

Investors can potentially benefit from exposure to either triple- or double-B quality cohorts, but together they create a very broad and diversified asset class. While there is a significant divergence in the industry composition of the broad high yield and investment grade markets, there is a high degree of similarity between the triple-B and double-B segments, which allows investors to substitute within the crossover market depending on market conditions and relative value.

Q: What makes crossover bonds distinct from pure investment grade or high yield space?
A: When it comes to investing in corporate bonds, the number one risk is credit risk: the risk of loss of principal or interest stemming from an issuer’s failure to pay – default. Yields increase gradually from the highest quality investment grade tier (triple-A) to triple-Bs and more significantly from double-Bs to the lowest quality high yield tiers of single-B and C to compensate for the higher credit risk; default rates, however, grow at almost exponential increments across the high yield landscape, especially approaching the lowest quality tiers (Figure 5).

For instance, the pick-up in the average default rate from single-B rated bonds to triple-C and below is 11 percentage points (from 1.2% to 12.2%) for just a 4.4% average pick-up in yield. But when moving from the lowest level of investment grade (triple-Bs) to the highest level of high yield (double-Bs), the pick-up in the default rate is less than 0.2 of a percentage point while the pick-up in yield is 1.6%. This relatively large pick-up in yield, with such a negligible difference in credit risk, reflects the attractive premium associated with moving from high grade to high yield.

This premium has historically been high, as many institutional investors have strict guidelines that prohibit them from owning high yield bonds. As a result, many investment grade managers become forced-sellers when issuers are downgraded to high yield, creating valuable opportunities for investors without such restrictions. In contrast, most high yield managers with a focus on achieving high yields concentrate their exposure in the single-B tier of the high yield market, where yields can be markedly higher than those with double-B ratings. However, as represented in Figure 6, the best historical risk-adjusted returns of the high yield market have been found at the highest quality tier – among the double-Bs.

Risk-adjusted returns are derived from annualized performance divided by annualized standard deviation (Figure 6).

In fact, looking across the same time periods double-Bs outperformed on an absolute return basis in all but the 10- and 15-year periods, when they came in second place (Figure 7). With most managers focusing on either the investment grade or the high yield universe and very few dedicated funds targeting the intersection of the two markets, opportunities can arise for investors focused on crossover bonds.

Q: Where do crossover bonds fit within a broader asset allocation?
A: Crossover corporate bonds can have a place within most investors’ overall asset allocation. They tend to have a relatively low correlation to most fixed income sectors, in particular Treasuries and mortgage-backed securities, which make up the vast majority of a typical core fixed income benchmark (Figure 8). Crossover bonds can serve as a strong diversifier, offering an opportunity to achieve a higher yield, and thus greater income, in a prudent way from the perspective of risk-adjusted returns.

Crossover bonds generally also have a fairly low correlation to the equity market, furthering the case for including them in a broader asset allocation. The long-term strategic case for crossover bonds as an alternative to equity exposure is a strong one: Over the last 10-, 15- and 20-year periods, the crossover market has achieved at least 80% of the returns of the S&P 500 with less than half the risk (BofA Merrill Lynch and S&P).

With the Fed expected to raise interest rates, many investors are concerned about exposure to duration and the impact higher rates will have on their fixed income allocations. Moreover, with yields still at historically low levels, many are seeking ways to achieve higher yields without a material increase in credit risk. With shorter maturities, high yield bonds tend to have lower durations than other bonds. So we believe the crossover segment can offer a lower duration alternative to core fixed income and pure investment grade allocations with a low correlation to government rates for a marginal increase in credit risk.

Finally, because one of the primary incentives for investing in the crossover market is the historically attractive relationship of performance and risk, it is worth noting that the compensation per unit of risk is currently in line with historical norms, at approximately 1.33% annualized return per unit of volatility (Figure 9).

With the recent increase in volatility in Treasury rates, the energy sector and European sovereign credit, to name just
a few, we think both the strategic and tactical cases for crossover bonds are compelling today.

Q: How does PIMCO manage corporate crossover bonds in portfolios?
A: Among all corporate fixed income securities, crossover bonds are the most susceptible to upgrades to investment grade and downgrades to high yield due to their proximity to both rating categories. Therefore, we believe it is important to take an active approach to crossover bonds and have the resources to identify companies that have improving fundamentals and the potential to be upgraded to investment grade (“rising stars”) and avoid those credits where fundamentals are deteriorating.

PIMCO has managed dedicated crossover bond portfolios since 2001, and crossover bonds have also been a vital part of our core bond strategy for many years. With more than 60 credit analysts, our team is unique in that we do not specialize by credit quality – high grade and high yield – but rather by industry. This allows our analysts to better assess the impact of broad industry themes on all issuers, which we believe is critical to successfully managing a strategy that straddles both the investment grade and high yield universe.

The Author

Hozef Arif

Portfolio Manager, High Yield

Michael Brownell

Product Manager, Credit

Related

Disclosures

Past performance is not a guarantee or a reliable indicator of future results. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Equities may decline in value due to both real and perceived general market, economic and industry conditions. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. Diversification does not ensure against loss.

The correlation of various indexes or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility. Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market.

The BofA Merrill Lynch US Diversified Corporate Crossover Index is designed to measure the performance of US dollar denominated BBB and BB corporate debt publicly issued in the US domestic market. “Crossover” corporate debt generally means corporate debt rated at levels where the lower end of investment grade debt and the higher end of high yield debt meet. Qualifying securities must be rated BBB1 through BB3, inclusive (based on an average of Moody’s Investors Services, Inc. Fitch, or Standard & Poor’s, Inc.. Qualifying corporate issuers must have a primary risk exposure to an FX G10 or Western European country, or a territory of the US or a Western European country. The BofA Merrill Lynch US Corporate Index is an an unmanaged index comprised of U.S. dollar denominated investment grade, fixed rate corporate debt securities publicly issued in the U.S. domestic market with at least one year remaining term to final maturity and at least $250 million outstanding. The BofA Merrill Lynch U.S. High Yield Cash Pay Index is an unmanaged index that tracks the performance of below investment grade U.S. Dollar denominated corporate bonds publicly issued in the U.S. market. The BofA Merrill Lynch U.S. Treasury Index is an unmanaged index that tracks the performance of the direct sovereign debt of the U.S. Government. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. The Barclays Fixed-Rate Mortgage-Backed Securities Index is composed of all fixed-rate securitized mortgage pools by GNMA, FNMA, and the FHLMC, including GNMA Graduated Payment Mortgages. The Barclays U.S. Treasury Index is a measure of the public obligations of the U.S. Treasury. It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2015, PIMCO.