When it comes to fixed income investing, a high yield often comes with higher risks. Those borrowers with a greater risk for default often are given less favorable terms for their bonds. Balancing this default risk with income needs is one of the toughest jobs in managing a fixed income portfolio.
However, that job may be getting a bit easier.
It turns out that current economic conditions may allow investors to dial up their risk when it comes to bond investing, which, in turn, results in moving down the credit ladder. To that end, investors may be able to score higher yields and better returns for their fixed income portfolios.
Investors Bet Big on Junk
One of the biggest winners in the fixed income markets this past year has been high-yield or junk bonds. Companies and entities looking to raise money get rated by various agencies and are given a score. The best way to think of this is by looking at our credit scores. The high-yield market is made up of issuers that have the highest propensity for default and are rated Ba/BB, or lower. Historically, junk bond default rates have hovered between 3% and 5%, but during periods of economic distress, that rate is closer to 8%.
Which is what we have seen over the last year. As the Fed raised rates, prices for junk bonds fell — driven by the economic uncertainty that higher rates cause and the overall inverse relationship that bond prices and rates have. Investors have been able to snag yields on junk in the 8% to 10% range.
And as the Fed has paused on its path to higher rates and has continued to speak of dependent rate cuts, junk has been quite resilient. In fact, it’s one of the few areas of the bond market to generate real total returns.
Since the beginning of 2023 till the end of the first quarter of this year, the junk bond market has rallied by 14.5%. This compares to just a 2.88% return for the broader Bloomberg Aggregate Index over the same time.
Lower Ratings, Higher Returns
What’s interesting is that it’s not higher-rated junk bonds that are driving the bus — it’s those on the lower end of the rating scale. Looking at segment and credit band returns, we see some larger gains.
For example, CCC-rated debt has managed to outpace the broader junk bond market, delivering a 21.61% return during the same period. Going further down the ladder — Ca- and below-rated bonds — generates a 31.5% return. This has been one of the best runs in terms of history.
The reasons have been the economy and how lower-rated firms have prepared themselves.
As we said, junk bonds are very tied to the economic health of the nation. An investment-grade firm like Microsoft has plenty of levers to pull if the economy starts to deteriorate. It has really run into trouble for it to default on its debts. That’s not the case for a lower-rated junk bond firm. Like a person living paycheck to paycheck, often these firms need conditions to go just right to make sure they don’t default.
Today the economy is slowing, but it hasn’t stalled. Consumers are still spending, businesses are still growing, and labor markets are still robust. Moreover, inflation seems to be finally getting under control, prompting the Fed to consider cutting rates. All of this is great news for junk bonds — particularly those on the bottom end of the scale. They’ll simply have more cash flows to pay their debts.
Speaking of the debts themselves, lower-rated junk issuers are in much better shape than ever before. This is because many of the lower-rated junk issuers were able to use the last few years of zero-rate interest policies to improve their interest expenses. According to asset manager abrdn, the average coupon payment for CCC-rated firms now sits at 7.24%, which is over 200 basis points below peaks reached in 2010 and the lowest point since the end of the Great Recession. 1
This is key since interest rate expense is often the biggest hurdle for lower-rated firms as free cash flows are generally non-existent.
A Potential Value
So, returns for lower junk bonds have surpassed better-rated ones; they offer high yields; and they are in a better credit position with the improving economic trends. That’s already a great win for lower-rated junk.
But there is another reason why investors may want to consider moving down the credit ladder. They offer a bigger value than the rest of the junk bond market. That’s because they haven’t traded through historical averages like BB- and B-rated high-yield bonds. This chart from abrdn shows the average option-adjusted spreads for the broader high-yield market and CCC-rated bonds.
Source: abrdn
According to abrdn, higher-rated junk bonds are keeping the option-adjusted spread (OAS) low, and looking at data, CCC credits have the potential to move higher as the mean reversion occurs. This is evident by the fact that the overall high-yield market closed the first quarter at a +299 basis point when looking at OAS. This has only happened a handful of times since the Great Recession, and when it has, CCC debt has moved higher.
For investors, this means that if they want to realize strong junk bond returns going forward, it may make sense to move down the credit ladder. With CCC debt, they could score higher yields and some real capital appreciation, all while not taking on too much more risk.
You certainly can try and buy lower-rated bonds. However, as with much of the junk bond market, bid-ask spreads are very large, and it can be tough to sell these bonds in an emergency. The answer may be ETFs or funds.
Currently, after a closure, there is only one ETF that purely hones in on this market. However, strong active managers in the sector should be pivoting towards these bonds. Those investors not willing to take such a concentrated approach to adding CCC debt could use an active fund with more exposure to this area.
Junk Bond ETFs
These funds were selected based on their exposure to junk bonds. They are sorted by their YTD total return, which ranges from 10.6% to 12.9%. They have expense ratios between 0.05% and 1.02% and assets under management between $0.31B and $15.2B. They are currently yielding between 4.8% and 8.4%.
| Ticker | Name | AUM | 1Y Total Ret (%) | Yield | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| XCCC | BondBloxx CCC Rated USD High Yield Corporate Bond ETF | $0.31B | 12.9% | 12.01% | 0.40% | ETF | No |
| SRLN | SPDR Blackstone Senior Loan ETF | $4.6B | 12.6% | 8.4% | 0.70% | ETF | Yes |
| USHY | iShares Broad USD High Yield Corporate Bond ETF | $9.4B | 12.5% | 7.2% | 0.08% | ETF | No |
| SPHY | SPDR Portfolio High Yield Bond ETF | $1.36B | 12.5% | 8.0% | 0.05% | ETF | No |
| JNK | SPDR Bloomberg High Yield Bond ETF | $8.51B | 12.1% | 6.7% | 0.40% | ETF | No |
| HYLB | Xtrackers USD High Yld Corporate Bd ETF | $3.93B | 11.9% | 5.8% | 0.20% | ETF | No |
| HYLS | First Trust Tactical High Yield ETF | $1.54B | 11.8% | 6.5% | 1.02% | ETF | Yes |
| HYG | iShares iBoxx $ High Yield Corporate Bond ETF | $15.2B | 11.4% | 6.8% | 0.49% | ETF | No |
| PHB | Invesco Fundamental High Yield Corp Bd ETF | $0.55B | 10.6% | 4.8% | 0.50% | ETF | No |
In the end, junk bonds offer some compelling yields. And lower-rated debt offers value and better returns on top of those yields. With the economy still churning forward and the Fed potentially cutting rates shortly, investors have a real chance at gains. Positioning themselves accordingly in lower CCC-rated debt may make sense.
Bottom Line
Lower-rated junk bonds have been the star of the show over the last year. With returns and yields outpacing higher-rated junk, they still may be valued given the economic growth and Fed rate cutting on the horizon. For investors, they offer an opportunity to score a great total return.
1 abrdn (April 2024). To CCC, or not to CCC