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Upside funk: navigating negative convexity

Strong performance in credit markets since the start of this year means that many high-yield bonds now trade at or close to their full valuation. This phenomenon, known in credit markets as negative convexity, is back and we believe that high conviction, bottom-up security selection is needed to identify attractive alternatives to callable bonds. Looking throughout the capital structure, we think that certain secured bank loans have the potential to deliver superior risk-adjusted returns in this environment.

No room to grow

Credit markets have delivered impressive returns this year across most sub sectors, including global high yield where a large share of bonds now trade to call – in other words, near or at their full valuation. It seems likely that future price rises will be capped by potential call activity1 and that investors will not earn the full yield to maturity. Almost 90% of callable BB-rated bonds now trade to call and negative convexity in this market is at its worst level since the 2013 taper tantrum.  

The situation becomes worse in a bear market. If these bonds are repriced to their final maturity, they will probably suffer disproportionately in relation to non-callable securities. In short, it’s a no-win situation for many developed-market high-yield bonds.

The gap between the quoted yield to maturity and yield to worst is wide in developed markets (see figure 1). This is largely due to the low interest-rate environment, one of the unintended consequences of which has been lower coupon sizes and call-price levels.

Figure 1. Ratcheting up

Source: ICE bond indices, Hermes, as at November 2019.

Scouring the capital structure

In this environment, security selection should take precedent over issuer selection. One approach could be to take on a risk position through credit-default swaps (CDSs) – insurance contracts against a bond default, which are not callable – rather than bonds (see figure 2).

Figure 2. Significant negative basis

Source: ICE bond indices, Bloomberg, Hermes, as at November 2019.

Investors that allocate to CDSs rather than bonds maintain exposure to a firm’s unsecured debt, but without having to sell what is now a very valuable call option to the company. CDS contracts have no call options embedded in them, which means they offer investors greater potential to achieve capital appreciation than bonds currently do at these elevated, constrained levels.

But CDS premia are currently expensive at a broad market level when compared to high-yield spreads. Beyond a few idiosyncratic expectations, investing in CDS does not seem a good way to proceed.

Compelling value: secured bank loans

In recent weeks another avenue to issuers’ credit risk has become increasingly attractive: secured bank loans that have become dislocated from their fundamentals. Leveraged loans have had a tough time this year as demand for floating-rate products has fallen along with interest rates. Investors have also become concerned that the structure of the asset class is changing: looser covenants, or contractual terms governing the conduct of borrowers, are becoming common and some companies are adopting loan-only capital structures.

Redemptions by retail investors, indigestion of collaterised-loan obligations and the fact that supply has not slowed have caused notable softness in the market. In turn, this has created some clear opportunities.

Amid very poor convexity, high-yield loans usually trade well above par. But continued outflows have seen them trade at about $99 in recent weeks (see figure 3). This provides an opportunity to switch from bonds with extreme negative convexity into loans with a better convexity profile. These loans also have a higher position in the capital structure, which offers investors first claim on cash flows and priority in a restructuring event.

Figure 3. Dislocated valuations in the leveraged-loan market

Source: Bank of America Merrill Lynch, Credit Suisse, Hermes, as at November 2019.

But capitalising on this opportunity is difficult and requires a nuanced approach. To benefit, investors need to take a holistic look at a company’s entire capital structure to decide whether to access the loan, bond or CDS.

Goodyear and Avis: moving on up    

Bottom-up research recently helped us identify an opportunity to rotate out of the callable bonds and into the loans of current holdings Goodyear, a tyre-maker, and Avis, a car-hire company. Despite suffering from lower margins and higher leverage, both firms have taken creditor-friendly actions to protect their balance sheets and the respective management teams seem committed to improving financial performance.

As a result, both issuers remain attractive investment propositions. But to compensate for the risks associated with investing in unsecured instruments, the firms needed to offer investors potential to grow their capital. Avis and Goodyear’s unsecured bonds have traded above call in recent months and as a result their loans looked more attractive (see figure 4).

Figure 4. Relative value between the bonds and loans of Goodyear (left) and Avis (right)

Source: Bloomberg, Hermes, as at November 2019.

Around the time we changed our positioning, Goodyear’s secured loan was trading below par at around $99.75 – compared to its bond at $101.60 – which provided room for around 25bps of capital appreciation. It also has a higher rating than the company’s bond, a more senior position in the capital structure and a shorter maturity.

While Avis’s loan has traded just above par recently, it offers similar spread levels to its bond. The loan also has the more defensive characteristics typical of loans and, unlike the bond, is investment-grade status.

Staying flexible

The performance of credit markets this year means that high-yield bonds currently offer very little upside. But as we found with secured bank loans, opportunities do exist elsewhere in the capital structure. Through our range of flexible-credit strategies – Multi Strategy Credit, Unconstrained Credit and Absolute Return Credit – we have the mandate to act nimbly and identify high-conviction, idiosyncratic stories that have the potential to deliver superior risk-adjusted returns.

  1. 1Call features are contractual rights that enable issuers to refinance at a predetermined price, no matter how much the bonds have rallied at the call date.
Risk profile
  • Past performance is not a reliable indicator of future results.
  • The value of investments and income from them may go down as well as up, and you may not get back the original amount invested.
  • It should be noted that any investments overseas may be affected by currency exchange rates.
  • This information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.
  • Where the strategy invests in debt instruments (such as bonds) there is a risk that the entity who issues the contract will not be able to repay the debt or to pay the interest on the debt. If this happens then the value of the strategy may vary sharply and may result in loss. The strategy makes extensive use of Financial Derivative Instruments (FDIs), the value of which depends on the performance of an underlying asset. Small changes in the price of that asset may cause larger changes in the value of the FDIs, increasing either potential gain or loss.

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