Risky Bonds Shine Amid Volatility
In today’s topsy-turvy credit landscape, investors are flocking to high-yield bonds and other riskier debt instruments, seeking refuge from the uncertainty of government bonds. This unexpected trend is driven by a growing focus on interest income, or “carry,” as market players seek to offset falling values in a rising yield environment.
The Carry Conundrum
With strong inflows into credit funds compressing spreads, money managers are looking for alternative ways to beat their benchmarks. Low-rated and junior bonds have become increasingly attractive, offering higher coupons that help offset losses when yields rise. This phenomenon is so pronounced that high-yield securities have outperformed their blue-chip counterparts during recent market turmoil.
Subordinated Securities Shine
Subordinated notes, such as contingent convertibles (CoCos), have also performed strongly, boasting impressive Sharpe ratios. This has led many to conclude that carry is the dominant theme of the year, with even the most risk-averse assets, like sovereign bonds, experiencing high volatility.
Fiscal Deficits and Interest Rate Uncertainty
Fiscal deficit concerns are making government bonds less appealing, while differing interest rate cut paths have made riding an expected decline in yields a risky strategy. As a result, investors are turning to credit markets for stability, where spreads are seen as less volatile than the risk-free rate.
Duration Matters
High-yield bonds typically have shorter durations than high-grade notes, making their prices less sensitive to yield changes. This has helped junk bonds weather recent market storms, with a Bloomberg-compiled global junk bond gauge showing a relatively modest year-to-date loss of 0.57%.
Refinancing Risks Loom
However, questions about refinancing costs are emerging, as many notes coming due feature relatively low risk premiums. Investors must be cautious to avoid bonds with refinancing issues, lest they get caught in a losing game of “picking pennies up in front of a speeding train.”
Carry: The First Line of Defense
Assuming the borrower doesn’t default, investors can expect to earn at least the coupon payment, making carry a crucial aspect of credit management. As Ninety One portfolio manager Darpan Harar notes, “Your first line of defense as credit manager is carry.”
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