Just like the weather, fixed income indices evolve. Sometimes those evolutions suit investors, sometimes they don’t. And sometimes they provide opportunities that an active manager can exploit. The important thing is to do something about it: to analyse what happened and figure out if the change creates an opportunity.


Today, BB rated high yield bonds are offering nearly four times the spread of BBB bonds – double its historical average – when adjusted for their differences in spread duration. Is this just another unpredictable change in the weather or is it an opportunity?


Because we now understand better the role that interest rate duration has played in the historical relationship between BB and BBB bonds, we can consider the role the US Federal Reserve (Fed) may play in how their future relationship may evolve. We think the Fed is more likely to raise policy rates from zero than they are to make them negative. And, if the risk in longer-maturity Treasury rates is thus more skewed to higher rates than lower ones, then perhaps the decade-long trend of rising BBB spread durations will fade. Put simply, if lower borrowing costs increased spread duration over the last decade, higher borrowing costs may not lower the spread duration, but they could temper its rise.


Besides the nearly four times spread advantage of BB bonds over BBB bonds, another advantage of favouring BB rated ones in today’s market is the greater prevalence of potential ‘rising stars’ – companies that could see an improvement in their credit rating given the stronger economic outlook, moving them up and into the investment grade corporate bond market.


While picking and choosing among these potential stars does require extensive expertise and research, we take to heart the old tip for chess players: never make a move for fewer than three reasons. If BB bond spreads look attractive on a historical basis and even more attractive on a spread-duration adjusted basis, and the BB universe is sprinkled with potential rising stars, and there may be good reason for BBB spread durations to slow their pace of appreciation, then perhaps one should allow the chess clock to tick for a few minutes longer and consider the potential opportunity that making a move into the BB space could provide.



1The term coupon refers to the agreed periodic interest payments in a bond’s contract. Historically, bond contracts were paper certificates which contained coupons that needed to be detached and physically presented to receive the interest payment. Thus the phrase “clipping the coupon” became shorthand for owning a bond and receiving the regular interest payments because actual scissors were used to clip off the coupons.


2We put ‘risk free’ in quotes because while that is the common way to refer to risk in US Treasuries, the phrase specifically refers to Treasuries’ lack of credit risk, but not a lack of volatility risk.


Corporate bonds are bonds issued by a company.


Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. The principal on mortgage or asset-backed securities may normally be prepaid at any time, which will reduce the yield and market value of these securities. Investing in derivatives entails specific risks relating to liquidity, leverage and credit and may reduce returns and/or increase volatility.


Credit spread is the difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing indicate improving.


Duration measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.


High yield bond is a bond that has a lower credit rating than an investment grade bond. These bonds carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher coupon. They involve a greater risk of default and price volatility and can experience sudden and sharp price swings.


Yield is the level of income on a security, typically expressed as a percentage rate. For a bond, this can be simply calculated as the total annual coupon payment divided by the current bond price.


Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.