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How to Profit From Two Inefficiencies in the High-Yield Bond Market


It's easy to get into trouble in the junk-bond market, where credit quality and liquidity can deteriorate quickly. Higher-quality high-yield bonds are likely better bets for long-term investors than exchange-traded funds that track the broad high-yield market, and not just because they carry less risk. These bonds are more likely to be undervalued than their lower-rated counterparts. This owes to mispricing that can arise from two inefficiencies in this market: yield-chasing and forced selling. Here's a closer look at why these inefficiencies exist and how to profit from them.
Credit Risk Doesn't Always Pay
Over the long term, there should be a positive relationship between credit risk and returns. Investors expect to be compensated for bearing credit risk. Otherwise, no one would take it. Understanding this, lower-rated bond issuers tend to offer higher yields to attract investors.
As shown in Exhibit 1, there was a positive relationship between credit risk and returns from the highest-rated corporate bonds (AAA) through the highest-quality level of junk bond (Ba), from July 1983 through January 2020. Each step down the credit rating ladder came with a comparable or slightly better return. This is the relationship between risk and reward that investors would expect.

However, within the confines of the junk-bond market, this relationship gets turned topsy-turvy. Here, returns declined with each step down the credit rating ladder. The underperformance of the lowest-rated debt is persistent, as shown in Exhibit 2.

This is hard to reconcile with classic financial theory, which assumes risk and expected returns should be inexorably linked. This surprising relationship isn't the result of inaccurate credit ratings. Lower-rated bonds had progressively higher default rates and credit losses than higher-rated bonds (1).
It's possible that investors understood the lowest-rated bonds' credit risk and thought they were getting sufficient compensation, but they just had a long string of back luck where realized credit losses exceeded their expectations. However, aggressive yield-chasing is the more likely culprit.
Lower-rated bonds tend to offer higher yields than those with higher ratings. This may be because they are trading at a deep discount to par value, offer a high coupon rate, or some combination of the two. This can make them attractive to income-oriented investors, who prioritize current income over capital gains, sometimes to the detriment of total returns.
Even professional money managers aren't immune to overpaying for bonds with shaky fundamentals. Lower-quality bonds offer greater upside potential than their higher-quality counterparts, which could make them appealing to active managers who are trying to beat their benchmarks. However, their collective bets on those securities could push their prices above fair value, leading to disappointing long-term performance (2). Managers may also be overconfident in their ability to identify low-quality issuers with improving fundamentals and discount the risks.
A Sweet Spot
While Ba rated corporate bonds aren't enticing enough for many high-yield bond investors, they are too risky for many investment-grade investors. This has not only allowed them to deliver higher returns than all other rated corporate bonds, but also better risk-adjusted performance.
It's not realistic to expect Ba bonds to post better returns than the broad high-yield bond market indefinitely. As more investors become aware of the meager compensation the lowest-rated junk bonds have historically offered, they are likely to tilt away from those bonds, which should help create a more rational relationship between risk and return. However, as long as many continue to prioritize yield or upside potential over risk-adjusted performance, Ba bonds will likely continue to offer better risk-adjusted performance than the rest of the high-yield bond market.
How to Profit From This Inefficiency
Credit ratings are a good starting point for identifying higher-quality high-yield bonds, but they're probably not the most effective screen. Market prices tend to move faster than credit ratings. They usually start to decline ahead of ratings downgrades and appreciate with improving fundamentals that often precede rating upgrades. So, it's prudent to look at what the market is saying about each bond's risk, which can be gleaned from their yields.
That's the approach Xtrackers Low Beta High Yield Bond ETF takes. It targets high-yield corporate bonds whose 30-day moving average yield-to-worst (maturity or prepayment) is below the median value for their sectors. Bonds that make the cut are weighted by market value. This yields a broadly diversified portfolio that tilts toward BB rated bonds, as Exhibit 3 shows. However, its use of yield-to-worst instead of credit spreads (which control for duration) mixes interest-rate and credit risk, causing it to favor both bonds with higher credit quality and lower duration.

IQ S&P High Yield Low Volatility Bond ETF focuses more narrowly on credit risk. It targets high-yield bonds with low option-adjusted spreads and low sensitivity to changing credit spreads relative to the broad high-yield bond market. Bonds representing the less risky half of the market (by count) qualify for inclusion and are weighted by market value, subject to a 3% issuer cap.
There are no adjustments for sector membership, which allows this fund to have larger sector tilts than HYDW and mitigate exposure to troubled sectors. For example, energy represented about 11% of HYDW and iShares Broad USD High Yield Corporate Bond ETF based on data available as of February 2020. But energy issuers represented only 5% of HYLV. However, these sector tilts are a source of active risk that won't always pay off.
Like HYDW, HYLV favors BB rated bonds, but it has a longer duration, which will likely make it a bit more volatile. Both funds should offer lower volatility and better downside protection than the broad high-yield bond market and will likely lag in strong markets. However, they should offer more-attractive risk-adjusted performance over the long run.
Fallen Angels
Fallen angels should also offer better risk-adjusted performance than the broad high-yield bond market over the long term. These are a special breed of high-yield bonds that received investment-grade ratings when they were originally issued but were subsequently downgraded below that threshold. When those downgrades occur, many investors sell these bonds, as they are unwilling or unable to hold anything rated below-investment-grade. This forced selling can cause these bonds to become undervalued when they first enter junk territory.
Ratings downgrades are often concentrated in troubled sectors. For example, energy bonds represented about 17% of iShares Fallen Angels USD Bond ETF at the end of February 2020, which was greater than their weighting in the broad high-yield bond market. This is clearly a risk, but these sectors may be oversold and poised to offer better performance if their fundamentals recover.
Fallen angel issuers have enjoyed higher rates of subsequent upgrades to investment-grade status than other types of high-yield bond issuers, as they often seek to regain their former status, which can help their performance (3). This is partly because these bonds disproportionately sit at the higher-quality end of the junk market. Consequently, they also benefit from the same yield-chasing effect that can cause other higher-quality junk bonds to become undervalued relative to lower-quality bonds.
All this may explain why the ICE BofA U.S. Fallen Angel Index, which underpins VanEck Vectors Fallen Angel High Yield Bond ETF, outpaced the ICE BofA U.S. High Yield Constrained Index by 2.9 percentage points annually from its inception at the end of 1996 through January 2020. Exhibit 4 shows that this outperformance was fairly consistent.

Part of this outperformance can be attributed to the fallen angels index's longer duration. Fallen angels tend to be more sensitive to fluctuating interest rates than original issue high-yield bonds because they were initially able to borrow with lower coupon rates for longer periods. That said, fallen angels still posted more-attractive performance despite their greater interest-rate risk.
ANGL and FALN are both good choices for broad, market-value-weighted exposure to fallen angel bonds, though ANGL is slightly cheaper, as shown in Exhibit 3. ANGL more effectively guards against exposure to issuer-specific risk by capping its weightings at 3%, while FALN may allocate up to 10% to an individual issuer. Both would likely benefit, relative to the broad high-yield market, if the United States entered a recession, not only from their higher-quality tilt and longer-than-average duration, but also from the likely increase in downgrades among BBB corporate issuers and the accompanying selling pressure.
Key Takeaways
  • Higher-quality junk bonds will likely continue to offer better risk-adjusted performance than the broad high-yield bond market, as they are often less attractive than higher-yielding bonds to investors focused on income or trying to beat a benchmark.
  • Funds like HYDW and HYLV that target high-yield bonds with low yields offer a good way to get exposure to higher-quality junk bonds.
  • Fallen angels are likely undervalued because of forced selling pressure and low credit spreads relative to the high-yield bond universe. ANGL and FALN are good options for this exposure.
References
1) S&P Global Ratings. 2018. "2018 Annual Global Corporate Default And Rating Transition Study."
2) Frazzini, A., & Pedersen, L. 2013. "Betting Against Beta." NYU Stern.
3) Based on ICE data from Dec. 31, 2003, through Dec. 31, 2019.
Alex Bryan, CFA does not own shares in any of the securities mentioned above.

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