The game is up for CCC-rated bonds, whose near 30% returns last year propped many high yield investors’ portfolios, as a crash is on the cards for 2017, said AB’s Gershon Distenfeld.
In his latest market commentary the high yield veteran said last year’s outsized gains, which were nearly double that of the broader US high yield market, were mainly due to commodity prices stabilizing, leading to a rebound in the troubled energy sector bonds.
However, betting on a repeat performance this year is ‘akin to playing Russian roulette’, said Distendfeld, as while CCCs soared in 2016 they 'may crash this year'.
‘For one thing, the odds are heavily stacked against it. According to Moody’s Investors Service, CCCs logged an average default rate of more than 11% between 1994 and 2015, compared to 2.8% for B-rated securities,’ wrote Distenfeld, the group’s director of high yield and investment grade credit who runs the AB US High Yield Portfolio, among others.
‘What’s more, CCCs simply don’t have much room to rise further. The average dollar price in the sector was $67 when 2016 began; today it stands around $86. That’s historically high for the lowest-rated, highest-risk sector of the high-yield market.
With US interest rates expected to continuing rising this year, companies in distress will come under greater pressure as market conditions become even more challenging. In this environment, he said, it will pay off to stay clear of CCC’s, unlike in 2016.
‘Are there occasionally unique opportunities in this part of the high-yield market? Sure. But finding them requires extensive credit analysis and a very selective approach.
‘In fact, some of the best opportunities come after a bond has defaulted. As strategists at Barclays put it in a recent research report, “bonds lose an average of 30%–35% in the six months leading up to default, but then rally 20% in the six months following".’
Untold danger of HY’s junk
Distenfeld also warned of the negative impact CCC-rated bonds can have on a portfolio even before they default, a concept he believes is often misunderstood.
'Investors often tell us they chose a particular high-yield strategy because over time it suffered very few defaults—or none at all. But when these strategies include a large share of CCC-rated “junk” bonds, the statistics probably don’t tell the whole story.'
‘That’s because with distressed bonds, the steepest price declines usually come well before an actual default (that’s true of more highly rated bonds, too).
‘Now, it’s certainly possible for managers to unload a bond at pennies on the dollar and say their portfolios avoided a default. What they can’t say is that they avoided losses. By selling at a steep discount, they’ve actually locked in losses, no matter whether the issuers ended up defaulting or not.’
He added that high yield strategies that invest in the lowest quality corporate bonds have a ‘higher risk of being blindsided’ as it isn’t always obvious when a company is heading for trouble.
'Sometimes, markets anticipate default well in advance. Other times, a company’s fortunes go south much the way Ernest Hemingway said a man goes broke: “gradually, then suddenly".’
The AB SICAV US High Yield Portfolio fund has returned 10.49% over the past three years till the end of December 2016, while its Citywire-assigned benchmark BofA Merrill Lynch US High Yield Cash Pay TR USD rose 14.74%.