Sub-investment grade bonds can be broadly divided in BB-rated, B-rated and CCC & lower rated with the risk profile increasing in this respective order. The yields are naturally higher for the lower rated names but the movements are generally not synchronised. We’ve seen a recent example in the second part of 2014 when BBs returned 2.4% even as Bs posted negative returns. In contrast, year-to-date (YTD), BBs lagged behind their peers in the subsequent high yield bucket which recorded a 5% return.

Although this could, a prima face, be attributed to the risk-on environment which, once again, took hold of investors, it is enough to say that the return for CCCs was negative over the same period.

So what drives this divergence and how should a European investor position his/her portfolio? To start off, I would exclude CCCs and lower rated names from this discussion because their number is comparatively low and includes a large representation of Greek banks.

As regards the discrepancy between the B sand BBs performance, it largely boils down in my opinion to shifts in economic expectations.  The severe underperformance of the lower rated names in H2 2014 is in line with the growing macroeconomic pessimism observed at that time, the negative surprises delivered by the European economy and the fast decline in long term inflation expectations. As the lower rated names have smaller room for manoeuvre they reacted more aggressively to the revival of deflationary fears; the greater concentration of cyclical sectors in the B space provided more impetus to the sellers as the Automotive, Retail and Consumer Goods account for 22% of BoAML B Index and 11% of the BoAML BB Index.

Against this backdrop, B-rated yields increased sharply (bond prices fell), just a few months after touching record lows. At the start of the year, as it became increasingly obvious that the ECB had to take additional measures to support growth, we concluded however that the selloff was exaggerated and we pointed out that the spreads and yield ratios between Bs and BBs reached crisis-like levels. To put it differently, while we agreed that the economic growth will remain subdued we thought that the situation is not as grim as it was back in 2008 (which seemed to be what markets were pricing in). Long story short, we advised for an overweighting of the lower rated bonds and, for more risk adverse investors, for a blend of B and investment grade (IG) names.  

This seems to have worked out well as the B outperformed BBs and the spread ratio between the two is now at August 2014 levels. I think further compression could be envisaged as long as macroeconomic data remains supportive. This is because the BoAML B Index yields some 200 bps more than the BoAML BB Index, a significant yield pickup in the current environment and higher than what we observed in H1 2014 (below 150 bps). Also, while EUR BBs yields are close to the 2014 lows, Bs have not yet recovered.  Having said this, significant over-performance seems less likely now than it was a few months back given the persistently low long term inflation expectations and Greek-related uncertainties.

What is more, after a strong start to the year, I see the possibility of investors taking more calculated risk as they await clearer signs that QE is feeding into economy and that the recent upswing in data is sustainable. This could benefit BBs which offer a higher yield alternative to IG paper and more measured exposure to the business cycle as compared to Bs. 

This brings me to another important development. Following the rapid fall in IG yields so far this year from 0.8% to 0.48%,  IG focused investors could gradually look to shift part of their money into high yield. Comparing the spreads of the lowest rated IG bonds (BBBs) to those of the highest rated sub-investment grade bonds (BBs) I find that this trend could indeed gather pace. The spread gap between the two is the highest since mid-2013, while the yields for BBs are 2.4 times higher than for BBBs, the highest ratio since 2009.

The shift could find support particularly as IG yields seem to have hit a hurdle following strong issuance and the fact that they are now only several basis points away from those of Japanese corporates.

To add to my argument, I add that several larger insurance companies, such as Zurich Insurance Group and Assicurazioni Generali have reportedly started buying high yield bonds., albeit in a contained manner.

This article was issued by Raluca Filip, Investment Manager at Calamatta Cuschieri. For more information visit,www.cc.com.mt . The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.

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