Crossover bonds

02-11-2020
Crossover bonds

The sweet spot for fixed-income portfolios

 

As fears over a global slowdown continued to mount in 2019, central banks around the world proactively cut rates as a way to stimulate growth and help stave off a global recession. While many fled equity markets for the safety of bonds, investors today face the challenge of finding sufficient yield in today’s low-rate world.

In an environment where every basis point counts, is there a solution to enhance the yield in your fixed-income portfolio without taking on too much risk? We believe a crossover bond strategy might provide the yield boost investors are seeking for their fixed-income portfolio, especially in a falling-rate environment.

What are crossover bonds?

Simply stated, crossover bonds generally refer to corporate securities that are rated close to the dividing line between investment-grade and high-yield debt. For many fixed-income investors, crossover bonds occupy the “sweet spot” because they offer relatively high yields and low default rates (see Diagram 1).

Three key reasons for owning crossover bonds

1. Offers the potential for high-yield-like returns with less volatility. Crossover bonds deliver a strong risk-reward potential. As the Diagram 2 illustrates, crossover bonds have historically delivered similar returns to high-yield debt but with just two thirds of the volatility. They also outperformed investment-grade bonds with only slightly more volatility.

2. Offers the potential for enhanced portfolio diversification. With their low correlation to 5- and 10-year Treasurys, crossover bonds may deliver enhanced diversification and less interest-rate sensitivity in a fixed-income portfolio.

3. Takes advantage of market dynamics (price distortions) that tend to surround credit downgrades from investment grade to high yield (fallen angels) and credit upgrades from high yield to investment grade (rising stars).

Price distortions can occur when bonds move between the investment-grade and high-yield space, often due to forced selling triggered by rating events. Fixed-income portfolios that have an investment-grade-only mandate are restricted from holding non-investment-grade bonds. This often results in the forced selling of downgraded bonds (i.e., fallen angels), which can trigger a significant selloff of the downgraded security – and a sharp drop in price.

In a crossover strategy, a manager can exploit this distortion and buy bonds well below their intrinsic value. The reverse occurs with rising stars, which once upgraded, will be highly sought after by investment-grade-only portfolios, thus bidding up their price.

Performance in a falling-rate environment

Let’s see how crossover bonds have performed in rate-cutting cycles versus high-yield bonds. We examined the last four Federal Reserve rate-cut cycles, with an average cycle length of 2.5 years1.

Over each cutting cycle, we compared the performance of crossover bonds to high-yield from the beginning of the rate cut cycle over a 2.5-year horizon2. In three of the four cycles examined, crossover bonds outperformed high-yield and with less volatility.

Additionally, because the high-yield space has a lower duration than the investment-grade bucket, exposure to crossover bonds will lower the duration of your fixed-income portfolio. This is advantageous in a declining rate environment.

Outlook positive for crossover bonds

In a rate-cut cycle, having exposure to crossover bonds is an attractive strategy to enhance yield – without adding too much risk to your fixed-income portfolio.

As more investors turn to ETFs to form a part of their investment plan, the demand for active management within the structure has increased. Actively managed ETFs, such as Dynamic iShares Active Crossover Bond ETF (TSX: DXO), which invests primarily in North American fixed-income corporate securities that are rated close to the line dividing investment-grade and high-yield credit, may be able to help meet this demand as they have the power to differentiate client portfolios by uncovering opportunities beyond the benchmark.

Mark Brisley is Managing Director and Head of Dynamic Funds, one of Canada’s largest asset management companies. With over 25 years of industry experience, Mark is responsible for the firm’s strategic execution, day-to-day business operations, and business development. This article previously appeared in the Fall 2019 issue of Your Guide to ETF Investing, published by BrightsRoberts Inc. Used with permission.

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