(Bloomberg) -- In today’s topsy-turvy credit world, risky bonds are outperforming safe ones in periods of volatility. The reason? An increasing focus on interest income, or carry in industry parlance.
Strong inflows into credit funds have compressed spreads — the premium for buying corporate debt rather than safer government bonds — so much that further tightening looks unlikely. That’s left money managers seeking other ways to beat their benchmarks. Low-rated and junior bonds are increasingly attractive to them because the higher coupons they typically pay help offset falling values when yields move up.
The trend is so powerful that high-yield securities dropped less than their blue-chip counterparts during the worst of the bond selloff earlier this month, even though the companies that issue them are more likely to go bust. A similar story is playing out with subordinated securities, which have performed strongly under a measure that compares investment returns with risk known as the Sharpe ratio.
“This is reinforcing the view that carry is the flavor of this year. The lowest-risk assets” — sovereign bonds — “have been the most volatile and you have recently got the best Sharpe ratios in things like CoCos,” said Ninety One portfolio manager Darpan Harar. CoCos, an abbreviation of contingent convertibles, are a type of subordinated note issued by banks.
Risky bonds are usually what investors call high-beta instruments: they gain more when times are good but lose more in bear markets. What’s different this time is that fiscal deficit concerns are making government bonds less attractive, while differing interest rate cut paths make riding an expected decline in yields as policy rates fall an uncertain strategy.
“People are starting to realize that credit spreads are not the volatile part now, the volatile part is the risk-free rate. It’s completely turned upside down,” said Flavio Fabbrizi, head of corporate debt capital markets for Europe at HSBC Holdings Plc.
Shorter Duration
Another factor is that high-yield bonds are typically shorter duration than high-grade notes, making prices less sensitive to yield changes. A Bloomberg-compiled global junk bond gauge has almost half the duration of its investment-grade counterpart, meaning that a one-percentage-point increase in yields will trigger double the price drop in safer bonds.
Even though junk bonds were caught in the recent selloff, triggered by concerns that the US Federal Reserve especially would have little reason to cut interest rates, the biggest year-to-date loss for the sector through Thursday was 0.57%, Bloomberg-compiled data shows. For high-grade bonds, it was about three times that and — unlike junk bonds’ strong rebound — they have barely managed to break even for the year.
Similarly, senior bonds issued mostly by European banks generally lagged Additional Tier 1 bonds, the riskiest type of bank debt, and remain in the red.
Still, questions about refinancing costs are also bound to emerge as many notes that are coming due feature relatively low risk premiums.
“You do have to be careful to avoid those bonds which may have refinancing issues because the spreads are not very high,” said Per Wehrmann, a high-yield portfolio manager at DWS Group. “Otherwise it can become like picking pennies up in front of a speeding train.”
Assuming the borrower doesn’t default, investors can expect to earn at least the coupon payment, making it particularly important when yield or spread movements are loss-making.
“Your first line of defense as credit manager is carry,” Harar at Ninety One said.
Week In Review
For decades, Hong Kong’s “big four” property dynasties have been viewed as cash-rich bastions of stability. A crisis of confidence at New World Development Co. is now putting that notion to the test.
Morgan Stanley and JPMorgan Chase & Co. scored another coup against private credit arrivistes this week when their leveraged finance teams snared a $1.2 billion deal from one of direct lending’s biggest borrowers, Ardonagh Group Ltd.
Morgan Stanley is among a trio of banks providing around €700 million ($728 million) of debt to finance private equity firm H.I.G. Capital’s acquisition of Kantar Media.
Building materials maker Quikrete Holdings Inc. launched a $3 billion loan deal on Friday that will help finance its roughly $11.5 billion purchase of Summit Materials Inc.
MidOcean Credit Partners’ investment in the riskiest part of its own collateralized loan obligations returned as much as 25% in 2024, according to a letter to investors seen by Bloomberg.
Altice USA Inc. held confidential talks with some of its creditors about a potential deal that would lower the telecom-infrastructure company’s roughly $25 billion debt pile.
Apollo Global Management Inc. is relying on its flagship Wagamama brand — and a booming bond market — to help cut borrowing costs at its UK restaurant unit.
Credit trading volumes reached a fresh record in 2024 and could hit a new high this year, potentially resulting in lower borrowing costs for US companies.
Spain received record demand for a syndicated bond deal Wednesday, the latest in a string of European debt sales attracting outsized orderbooks as investors seize on elevated yields.
Constraints on banks’ ability to take on risk is opening the door for private credit to go after their top-tier clients. And traditional lenders are determined to make the most of it.
On the Move
Sergey Goncharov, Vontobel Asset Management’s head of fixed income for the Americas, has left after nearly a decade.
Todd Ladda, a former Fortress Investment Group senior executive, has joined merchant bank BDT & MSD Partners to lead its global capital solutions group.
Banks across the Nordic region are on a hiring spree for their investment banking teams in preparation for what they expect will be a wave of mergers and acquisitions. Danske Bank A/S, Nordea Bank Abp, Jyske Bank A/S, Sparebank 1 Markets AS and Pareto Securities AS have all added dealmakers and corporate finance bankers in recent months and plan to expand their divisions further, they told Bloomberg.
--With assistance from Ronan Martin, Taryana Odayar and Dan Wilchins.
