October 01, 2021
Crossover bonds are a sweet spot on the credit-rating continuum. Historically, these corporate bonds rated between low BBB and high BB that straddle the intersection of the investment-grade and high-yield markets tend to offer attractive returns for the amount of risk being taken. From April 2006 through August 2021, the average annualized risk-adjusted return for crossovers was 2.2%, compared with 2.0% for high yield and 1.2% for BBBs, based on data from Bloomberg.
Note: Data are 2-year averages from April 2006 through August 2021.
Sources: Vanguard calculations, based on data from Bloomberg.
Past performance is no guarantee of future returns.
Economic downturns: Each time is different
Crossovers can include high-yield bonds on the path to being upgraded to investment grade (known as rising stars) and their opposite, investment-grade bonds that are at risk of being downgraded to high yield (fallen angels).
Although the COVID-19 pandemic initially triggered downgrades (fallen angels) at an unprecedented pace, much of the impact was, not surprisingly, centered on sectors affected by travel restrictions and social distancing. During the first seven months of 2020, the S&P Global Ratings credit-rating agency downgraded 40 issuers of a collective $340 billion in debt to junk status globally, including big companies such as Occidental Petroleum, Kraft Heinz, Carnival, Delta Air Lines, Renault, and Ford.
However, the major price dislocation anticipated by the markets pre-pandemic given the decade-long growth of BBB debt didn’t materialize. The liquidity infusion from swift action by governments and central banks globally and corporations’ ability to raise capital via the bond and equity markets limited the financial impact from business closures.
“In this environment, we were able to add significant value with crossovers,” said Min Fang, a U.S.-based Vanguard credit analyst. “We held on to some fallen angels that were fundamentally solid, which limited the potential loss from fire sales and resulted in outsized returns when those companies began to recover. We also provided liquidity to some corporations that were expected to recover over time—including airlines, cruise lines, and hotels—by purchasing new debt issued during the pandemic at very attractive levels.”
Where crossover opportunities stand now
For industries and companies that were facing long-term decline before the pandemic, business conditions could deteriorate further. For example, nonessential brick-and-mortar retailers are likely to face more difficulties as online shopping has accelerated in popularity during the pandemic. As a result, some fallen angels in those industries may remain in high-yield territory.
On the other hand, although some hard-hit industries such as airlines, hospitality, and leisure may see some structural damage to long-term demand for business travel, new demand spurred by global economic growth could provide some offsets. Fallen angels in these industries should recover over time to pre-COVID levels, enabling them to migrate back to investment grade.
And industries that are well-positioned to benefit from new trends emerging in the post-COVID world—including digitization, remote working, and supply-chain reconfiguration—may also see a return to profitability and thus potentially more rising stars.
“The opportunity set within the crossover universe has narrowed as the global economy recovers from the recession, and the spreads of risk assets have meaningfully tightened over the past 12 months,” said Bradley Marr, a U.S.-based Vanguard senior high-yield credit analyst. “We still have a number of avenues at our disposal, though, to add value.”
This is an abridged version of research published recently by Vanguard Fixed Income Group.
* Includes funds advised by Wellington Management Company LLP.
Note: Data are as of June 30, 2021.
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