Attractive opportunities in the “middle ground” of credit

While most corporate bond funds specialise in either investment grade or high yield securities, we believe some of the most interesting opportunities sit on the borderline between these two categories: the so-called crossover names.

Crossover credit mainly covers those bonds rated “BB” by the principal rating agencies. These companies will usually have more debt or greater cyclicality than investment grade issuers. The leverage ratio, which compares debt to earnings before interest, tax and depreciation, is typically between three and four times for BB-rated companies. This segment of the market is around half of the global high yield bond opportunity set by value and covers a range of economic sectors, including telecoms, autos, energy, healthcare, consumer products and financial services.

In general, we believe that these issuers offer reasonable risk-adjusted returns. The average US dollar yield on global BB companies at the end of February was roughly 7%. While the BB segment is classified as “non-investment grade”, we believe many of these companies are quite capable of servicing their liabilities over the medium term.

Moody’s data since 1983 suggests that the average loss rate for BB issuers is small: normally less than 1% per annum. Averages can be misleading, because there’s variation within the group, but we consider this level of delinquency quite manageable, especially with the help of active security selection. Defaults are not the only consideration: clearly there are other factors to consider, such as liquidity risk and downgrade risk, but generally we think BBs offer a compelling trade off of risk against reward.

In summary, we think the BB market offers a sweet spot for corporate bond fund managers where they can capture some of the yield from non-investment grade debt, without taking exposure to as many ‘blow-ups’.

What kind of companies are found in the BB space?

Double B issuers typically fall into one of four categories: First there are fallen angels. These were once strong investment grade companies that have dropped down to BB in recent years, such as Teva Pharmaceuticals or Ford.

Second, there are leveraged buyouts led by private equity sponsors, which would include Asda and Q-Park.

Third, subordinated financials account for a significant portion of European BB issues. Banks often issue subordinated securities to boost their capital base. These may have fixed term or in some cases be perpetual, loss-absorbing instruments. The majority of large European banks will also have BB securities in their capital structures, including Unicredit, Barclays, Deutsche Bank and Société Générale.

The final category is those issuers which choose BB status, because they consider around three times leverage to be the optimal capital structure. These voluntary double BBs do not necessarily want to be investment grade. They seek the benefits of financial gearing, without jeopardising the future of the firm. This is a large group within the double B segment, and includes healthcare issuers Grünenthal and Convatec.