In most credit cycles, the market hits a point when credit rating downgrades far exceed upgrades. This
ratings migration process can significantly impact the valuations of securities, particularly when credits are
downgraded from a rating of investment grade to high yield. Companies that go through such a downgrade
often are referred to as "fallen angels." The price dislocation that occurs as companies and sectors transition
from investment grade to high yield can present significant opportunity for experienced investors in what is
termed a "crossover market."
Crossover market opportunity
There are several reasons the crossover market and
fallen angels have offered investors willing to accept the
additional risks the potential for excess returns. But the
forced selling that often results from these credit
downgrades is the primary driver.
With fallen angels, many investment managers who
focus on investment grade securities have mandates
with limits based on credit ratings. In general, the
higher the credit rating, the larger the position size can
be in a specific credit. When a credit gets downgraded
to high yield, a manager invested in that security often
must reduce the position to get within the mandate’s
limits — and that means forced selling.
In addition, the investment grade market is
approximately five times larger than the high yield
market. Forced selling thus often occurs into the much
smaller market and the resulting price often adjusts
lower as the ratings transition happens. Fallen angels
also tend to be much larger companies with more debt
outstanding when compared to companies rated high
yield, which adds to the transition challenges from a
larger to a smaller market. In general, the more
downgrades that occur over a short period of time, the
more attractive the potential opportunities become on a
Market factors at work now
In latter 2015 and early 2016, commodity-based sectors
(particularly energy and metals) experienced significant
pressure downward in both the equity and debt markets.
As a result, many commodity-based companies were
downgraded in 1Q2016. This resulted in the majority of
the energy and metals sectors in both investment-grade
and high yield markets experiencing extreme price
volatility. This downward pressure on bond prices was
exaggerated by the forced selling that occurred, as many
former investment-grade companies were downgraded to
high yield (fallen angels).
To illustrate the price volatility that occurred during this
time, the average price of high yield bonds in the energy
sector according to Bloomberg Barclay indexes for the
investment-grade and high yield categories was $60 at
the end of February 2016. The investment-grade market
experienced similar pain with average price on bonds in
the energy sector at $91 per the Bloomberg Barclays
indexes. One year late at February 2017 month-end, the
same average prices were at $99 and $106 in the
Bloomberg Barclays High Yield and Bloomberg Barclays
Investment Grade indexes, respectively. It is important
to note that these prices were average prices for the
indexes; many individual names in the cross-over market
experienced more severe pricing action. Total return for
the high yield energy sector was 80% and investment grade
was 29% over the past 12 months ending February 2017.
Attractive risk-reward opportunities similar to what
occurred in the crossover energy sector over the past year
present themselves in various sectors and individual
names over the course of credit cycles. In times when
risk-reward opportunities are limited, it is generally a
prudent strategy to invest in the higher credit quality
(BBB rated credits) parts of the crossover market. In
other times, as was the case in early 2016, it definitely
paid to be more aggressive.
Historical returns offer a guide
Although the crossover market is not widely discussed
as a distinct market, it has been recognized with its
own returns and statistics for more than 20 years. The
total return history of the crossover market compares
favorably to both higher- and lower-quality credit
during that time.
For example, the annualized return for the crossover
market was 6.14% in 2011-2016, compared with 6.96% for high yield and 4.59% for investment grade.1 In 2009,
the last time crossover downgrades were material relative
to upgrades, the annualized return was 48.05%.2 Although
it may be unrealistic to expect a repeat of 2009’s total
return, we think the magnitude of expected downgrades in
2017 is comparable. On a risk-adjusted return basis for the
period 2011-2016 using the Sharpe Ratio, the crossover
result of 2.05 was slightly less than high yield at 2.66, but
exceeded investment grade at 0.63.3
Low correlation with interest rate moves
One way to examine the relationship between securities or
among factors is through “correlation” — a statistical
measure of how two securities move in relation to each
other. A correlation of +1 indicates the securities moved in
lockstep through a specific time period.
Securities in the crossover market historically have
not been highly correlated to interest rate changes, as
typically has been the case with investment grade credit.
In fact, the correlation between U.S. Treasuries and
crossovers is only 0.13 since 1984, compared with 0.79
for investment grade.
Based on this historical relationship, we believe
crossovers are not likely to be materially affected as
interest rates rise. In each of the eight years since the
onset of the global financial crisis, crossovers have not
had a single year in which they underperformed both
investment grade and high yield, based on returns in the
Bloomberg Barclays indexes.
Pursuing the potential now
In our view, investments in the crossover market offer
the potential for higher risk-adjusted returns versus the
high yield market, without the high correlation to interest
rate changes of investment grade credit. That’s an
important consideration in the current environment,
since the U.S. Federal Reserve has begun moves taking
interest rates higher.
History also shows that the crossover market has been
most attractive at the end of a credit cycle, when rating
dislocations were at their peak. For these reasons, we
think 2017-2018 offers a potential opportunity in the
crossover credit market.
1Source: Bloomberg Barclays. Cross-over returns based on BofA Merrill Lynch U.S. Diversified Crossover Corporate Index, which represents U.S. dollar-denominated BBB and BB corporate debt publicly issued in the
US domestic market; high yield based on the Bloomberg Barclays U.S. High Yield Corporate Index, which represents the U.S. dollar-denominated, high-yield, fixed-rate corporate bond market; investment grade
based on the Bloomberg Barclays U.S. Credit Index, which represents the investment grade, U.S. dollar-denominated, fixed-rate, taxable corporate and government-related bond markets. It is not possible to
invest directly in an index.
2Source: Bloomberg Barclays. Cross-over returns based on the BofA Merrill Lynch U.S. Diversified Crossover Corporate Index, which represents U.S. dollar-denominated BBB and BB corporate debt publicly issued in
the US domestic market.
3The Sharpe Ratio is a measure of risk-adjusted returns used to characterize how well the return of an asset compensates the investor for the risk taken. A positive Sharpe Ratio in a fund means the returns have
compensated investors for the risk they have taken.
Past performance is not a guarantee of future results. The opinions expressed are those of the Ivy Funds and are not meant as investment advice or to predict or project the future performance of any investment
product. The opinions are current through April 2017, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed.
Risk factors: Investment return and principal value will fluctuate and it is possible to lose money by investing. Fixed-income securities are subject to interest rate risk and, as such, the value of fixed-income securities
may fall as interest rates rise. Investing in below-investment-grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. An investment in a mutual fund is not a bank
deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. These and other risks are more fully described in a fund’s prospectus. Not all funds or fund
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