The Junkiest Corporate Bonds Divide Wall Street

(Bloomberg Opinion) -- Triple-C rated U.S. corporate bonds are in some ways the riskiest securities an investor can buy. Even though they’re at least seven steps below investment grade, they’re not considered destined to default. However, they easily could in certain circumstances.

Because of that, the debt is often seen as a bet on a strong economy and favorable business conditions. It has returned 9 percent this year, according to Bloomberg Barclays data, compared with a 2.8 percent gain for the aggregate bond index. At first glance, that seems pretty good. But the broad high-yield index, which includes less risky borrowers, is up almost the same amount, at 8.6 percent. As recently as April 12, triple-C securities were trailing the overall junk-bond market. 

The Junkiest Corporate Bonds Divide Wall Street

Ordinarily, such a return on the broad index would equate to gains of close to 15 percent for triple-C debt, according to strategists at Citigroup Inc. “The inability of triple-C credits to materially outperform has puzzled many investors,” Michael Anderson and Philip Dobrinov wrote. This means one of two things: Either triple-C securities are cheap, or bond traders aren’t fully buying into the risk-on environment. 

Wall Street doesn’t have a unanimous answer. Citigroup, in an April 23 report, laid out its argument for why triple-C bonds are notoriously tricky to group together and can’t be expected to stick to historical patterns of outperforming their higher-rated counterparts during rallies.

The beta of triple-C credits versus the high yield market is historically a volatile relationship. The average may be 1.7x, but the range of 12-month betas goes from 0.4 to 2.6x. This year’s results are unusual, but not unprecedented...

The unspectacular triple-C performance is intriguing because most investors expect the lowest-quality credits to materially outperform the overall high yield market during strong periods. It stands to reason that a rising tide lifts all boats, especially the ones that need the most water to float …

Unfortunately, the low-quality universe is not always a microcosm of the broader high yield market, and the universe is reflective of various currents. In particular, the current triple-C universe is beset with an abundance of secular challenges …

For investors looking for a beta “catch-up,” we advise caution. Idiosyncrasies are very likely to drive performance, and therefore we prefer single-Bs over Triple-Cs.

Idiosyncratic risks surely play a part here. Citigroup uses examples of flailing brick-and-mortar retailers and rural hospitals struggling with the trend toward urbanization, while a Barclays Plc research report noted that about a third of the triple-C index will mature over the next three years, heightening the possibility of nonpayment. But similar concerns haven’t been enough to stop investors from plowing into the debt over the past decade. 

It’s happening again, with some investors and strategists coming around to the idea that maybe triple-C bonds are cheap after all. Bloomberg News’s Allison McNeely discovered that BlackRock Inc., the world’s largest money manager with more than $6 trillion in assets, is overweight the securities, and Amundi Pioneer is considering opportunities in the rating category. “We’ve been in the camp that there’s still a little bit more of upside to markets,” said Jeff Cucunato, lead portfolio manager of BlackRock’s multi-strategy credit platform.

Perhaps the biggest vote of confidence, though, comes from Bank of America Corp. In an April 26 report, strategists Oleg Melentyev and Eric Yu made a bold proclamation: “A further CCC melt-up still appears inevitable to us.” 

Some of the key metrics in the HY market have reached new extremes. The trailing 15-week change in spreads, at -170bps, is among the top 5 historical record moves tighter for this index going back 20+ years. Among the other four instances are the recovery rallies from the depths of 2002 and 2008 recessions as well as the rebounds from the low points of EU sovereign crisis in 2012 and energy meltdown in 2016 ...

The bottom line is that the technicals are too hot at the moment for any of this to matter in the near term, and this understanding stands behind our expectation for a continued CCC melt-up.

So, there are two sides: Those who favor triple-C debt argue that there’s a bit more juice left to squeeze out of this high-yield rally, even if the rebound from last year looks extreme and unsustainable. The bearish strategists are cautious about wading into triple-C debt and break down which kinds of companies make up the index. According to Citigroup, about half is health-care, energy, retail and communications companies — precisely those that have too much leverage or face a much-changed business climate from even a few years ago. 

The bears seem to have the better argument. If an investor wants to roll the dice on a further risk-on rally — or a “melt-up” — equities are probably a better way to express that view, even if it’s just for liquidity and diversification. The S&P 500, naturally, has 500 different stocks, while the Bloomberg Barclays triple-C index has just 297 different bonds (the broad high-yield index has 1,921). If one company goes down, the whole index takes a hit.

It just doesn’t seem worth it at this point to take on excessive risk. Using the S&P 500 as a general gauge of risk appetite, it’s telling that as it climbed back toward record highs, investors pulled billions of dollars from equity funds. Relentless selling on the way to the top is a pretty clear sign that people are all too happy to take profits.

In the short term, BlackRock and Bank of America could be right, and triple-C bonds could crack double-digit returns. Junk-bond buyers have been starved for supply, with the volume of debt maturing exceeding the sales of new securities by the most since the financial crisis. Investors just don’t want to be the ones left holding the junkiest bonds when things go the other way.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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