Top-tier junk bonds produced safer returns than debt from the most creditworthy borrowers and the U.S. government over the past five years, a period that included the bankruptcy of Lehman Brothers Holdings Inc. and the biggest bond market swings on record.
The BLOOMBERG RISKLESS RETURN RANKING shows BB rated corporate bonds from U.S. issuers returned 9.5 percent in the period when adjusting for price swings. That’s best among 35 corporate global bond gauges and better than an index of Treasuries, considered the safest and most liquid investment. U.S. bonds rated BB had the lowest volatility and the fourth-highest total return of all groups.
Bonds of speculative-grade borrowers from Dish Network Corp. to Chesapeake Energy Corp. surged as two rounds of asset purchases by the Federal Reserve reduced yields on investment-grade debt and recurring market volatility hurt the riskiest bonds. While increasing risk appetite may make lower-rated debt more attractive, the yield margin on BB rated debt is still above its historical average.
“BBs have really been the sweet spot,” Brian Nold, senior high-yield portfolio manager at Seix Investment Advisors and sub-adviser of the $2.1 billion RidgeWorth Seix High Yield Fund, said in a telephone interview. “They are right in between the more rate-sensitive, investment-grade part of the market, where volatility is linked to movements in Treasury rates, and the more credit-sensitive parts of high-yield, like B and CCC.”
The speculative-grade U.S. bonds came out on top of the rankings over the past two and three years, and since the Sept. 15, 2008, failure of Lehman Brothers. They also had the best risk-adjusted return since the beginning of 2010, which factors out the 45 percent the index delivered to investors in 2009.
As evidence mounts that the economic recovery is gaining strength, investors are going further down the risk scale seeking higher returns. Bonds rated CCC and lower have returned 0.95 percent this month, better than all other tiers of company debt in the U.S.
The risk-adjusted return is calculated by dividing total return by volatility, or the degree of daily price-swing variation, giving a measure of income per unit of risk. The returns aren’t annualized.
The second-best performer in Bloomberg’s ranking over five years was Bank of America Merrill Lynch’s global BB rated index, which returned 8.7 percent, dragged down by higher volatility than the U.S. index. The Global Broad Market Financial index and the Global Corporates Banking gauge were the worst and second worst, rising 3.2 percent and 3.3 percent, respectively.
U.S. debt outperformed because investors prefer to buy domestic junk bonds during times of financial crisis, viewing the U.S. securities as safer, Bradley Rogoff, head of credit strategy at Barclays Capital, said in a telephone interview from New York.
“There are a lot of potential governance issues in other parts of the world,” Rogoff said. “When you are dealing with riskier companies, you need to think about bankruptcy regimes, corporate governance and many other things.”
The U.S. junk bond market is also larger than those overseas, making it more liquid and reducing volatility for outstanding domestic securities. About $82.6 billion of high-yield debt has been issued in the U.S. this year, compared with $21.5 billion in Europe, according to data compiled by Bloomberg.
“The U.S. high-yield market is most established, from an issuance and secondary-trading standpoint and driving that is a dedicated institutional buyer base that is in the market in good times and bad,” Seix Investment Advisors’s Nold said. “The European part of the market doesn’t have the deep, dedicated buyer base that we see here in the U.S.”
The par value of Bank of America Merrill Lynch’s U.S. High Yield Master II index is $980.5 billion, compared to $1.43 trillion for its Global High Yield index, the data show.
U.S. BB rated debt had a volatility of 5.2, the lowest of all indexes, including Treasuries with a volatility of 5.6. The lower total return for Treasuries, at 34 percent compared with 49 percent for the highest tier of U.S. speculative-grade debt, meant the index didn’t make the top 10 risk-adjusted ranking.
The rolling 60-day historical volatility on the 10-year Treasury note reached 36 in March, the highest on record, while the Standard & Poor’s 500 index rose to 19 last month, the highest since September 1990, Bloomberg data show.
Search for Yield
The Fed has taken extraordinary measures since the September 2008 bankruptcy of Lehman Brothers to inject liquidity into the financial system to lower borrowing costs. The central bank purchased $2.3 trillion of securities in two rounds of quantitative easing from December 2008 to June 2011 to spur economic growth through lower capital costs.
The 10-year Treasury yield fell to 1.72 percent Sept. 22, 2011, the lowest since at least 1962, reducing returns for securities linked to the government benchmark and forcing lenders to seek out riskier assets to boost returns. The Fed, which has held the benchmark interest rate at zero to 0.25 percent since December 2008, has pledged to keep it near zero through at least late 2014.
Money-market derivative traders expect the central bank may reverse course earlier. Treasury yields surged and money-market rates rose after Federal Open Market Committee members raised their assessment of the U.S. economy on March 13. The policy statement drove traders to bring forward the time when they predict the Fed will first lift its target of zero to 0.25 percent and damped speculation the Fed will buy more debt in a third round of quantitative easing.
‘Not Getting Paid’
Such a move, coupled with a strengthening economy, could drive lenders to lower-rated, higher-yielding CCC debt, Marc Gross, a money manager at New York-based RS Investments, said in a telephone interview. The average yield for BB bonds has fallen 10 percentage points since December 2008, Bank of America Merrill Lynch index data show.
“You’re not getting paid for both credit risk and interest rate risk,” said Gross, who rates BB bonds underweight. “There is a yield floor that investors demand for owning BBs and we are fast approaching that.”
Current low yields don’t match the risk-return profile, said Jeffrey Sherman, a money manager at DoubleLine Capital, a Los Angeles-based firm with $30 billion in assets under management.
“You make incremental yield, relative to U.S. Treasuries, very slowly and can lose it very fast,” Sherman said in a telephone interview. “The bonds can devalue 5 percent to 10 percent quickly when a crisis comes,” he said.
JPMorgan Chase & Co. researchers led by Peter Acciavatti downgraded BB bonds to underweight in a note on Jan. 20, in conjunction with an upgrade for CCCs, citing a reduction in systemic risk from Europe. BB rated bonds would remain attractive if Treasury yields were expected to remain low and stock market volatility would return, they said.
BB rated corporate debt still offers excellent spread relative to credit quality, Barclays’s Rogoff said. Those securities offered 214 basis points of extra yield margin as of March 19 compared to U.S. investment-grade debt, according to Bank of America Merrill Lynch index data. A basis point is 0.01 percentage point.
The option-adjusted spread, which fell to 404 basis points March 19, is still 10 basis points higher than the 394-basis point average for the index going back to 1996, the data show. The yield on that index has fallen to 5.8 percent March 19 from 16 percent in December 2008.
Dish Network’s $750 million of 7.75 percent notes that mature May 2015 rose to 113.75 cents on the dollar March 16, up from 71.44 cents November 2008, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The second-largest U.S. satellite-television provider behind DirectTV is rated BB- by S&P and had $7.49 billion of debt outstanding as of Dec. 31, according to a Feb. 23 regulatory filing.
“Dish has tremendous free cash flows, solid subscriber base and provides the cheapest form of entertainment,” said RS Investments’s Gross, who holds the bonds. “If you’re willing to hold it there is going to be value at the end of the day.”
Chesapeake Energy, the most active U.S. oil and natural-gas driller that is rated BB+ by S&P, saw its $669 million of 7.250 percent 10-year notes trade at 107 cents on the dollar March 16, up from 62 cents in December 2008, Trace data show. Domenic Dell’Osso, the company’s chief financial officer, said Dec. 1 that it will reach the investment-grade category this year.
“BBs have the best combination of interest rate and credit characteristics to make for a low-volatility asset class,” Ashish Shah, head of global credit investments at AllianceBernstein LP in New York, wrote in an e-mail. “Their wider spreads and shorter maturities make them less interest-rate sensitive in a rate sell-off. Their higher quality makes them less vulnerable in a credit down cycle.”