Harnessing bond ratings to unlock opportunities

Bloomberg Professional Services

This article was written by Vikas Jain, Co-Head of Fixed income and Systematic Research at Bloomberg Indices.

Corporate bonds, which account for a significant portion of the bond market, are typically categorized by ratings. At times, we tend to shrug off ratings as they are slow moving and often late in their reaction. However, as we show in our research, the impact of ratings on performance cannot be understated.

The annualized returns and risk-adjusted returns exhibit a tent-shaped pattern along the rating dimension with BB bucket having the highest return and risk-adjusted return. If we consider a one-factor Capital Asset Pricing Model (CAPM) for corporate bonds, with optional-adjusted spread as a measure of risk, we would expect excess returns to be increasing over the rating buckets. This pattern holds true from AAA to BB, but returns start to decrease from BB to CC. The lower rating bucket not only delivered lower returns but also did so with significantly higher volatility.

Skillful investors can use the volatility and higher drawdowns and stronger recoveries in the CC and CCC buckets to time the market swings. However, historical evidence suggests that, over the long term and through market cycles, these rating buckets may not provide returns adequately compensating the risks, especially compared to other rating buckets.

Tent shaped returns in bonds and equity markets

We compare the performance based on rating buckets in corporate bonds with performance based on volatility buckets in stocks. The main similarity is the lower risk-adjusted returns of high-risk assets in both markets, often attributed to investors overpaying for these assets in pursuit of lottery-type returns. On the other hand, the ‘low volatility’ anomaly which is well studied in equity markets does not hold true across rating dimension in investment-grade corporate bonds.

The historical return attribution to defaults, downgrades and upgrades for each rating bucket reveals that risk-seeking investors are compensated proportionally to the risks taken in investment-grade buckets, but the compensation does not extend to high yield rating buckets. This discrepancy between the two segments of corporate bonds contributes to the tent shaped performance observed across the rating buckets.

Majority of the BB rating bucket’s performance is attributable to its unique position between investment-grade and high yield. Investors seeking higher yields in lower rating buckets overlook BB rated bonds and investment-grade investors are typically restricted to invest in them.

Fallen angels and rising stars

Investment-grade investors are forced to sell fallen angel bonds, which are bonds that are downgraded to high yield. This selling typically takes place in a short window overwhelming the demand in the smaller high yield market. This causes disproportionate spread widening and price declines around the downgrade month, which often reverts once trading activity normalizes. BB rated bonds benefit the most from this temporary price dislocation.

Figure 2 illustrates the average performance of a fallen angel bond compared to its peer group. We compare fallen angel’s performance with other downgraded bonds within investment grade and high yield buckets. Bonds that are downgraded within investment-grade ratings don’t move as much as fallen angels. While bonds in high yield buckets, on average, recover slowly and not as much as the fallen angels.

The Bloomberg US High Yield Fallen Angels Index (I38842US), which invests only in these bonds, has outperformed the best performing rating bucket, BB, by about 2.5% per annum in the last 20+ years.

A flexible investor with potential to hold the fallen angels for 1 year after the downgrade would have achieved 32 bps per annum additional return historically. Effectively, instead of selling the fallen angels immediately after the downgrade, this index sells such bonds one year after the downgrade.

On the other hand, rising stars, which are bonds upgraded from a high yield rating to investment grade, also contribute to the BB rating bucket’s performance. The BB rating bucket benefits in the month of upgrade, when the passive investors tracking investment grade market buy these upgraded bonds. We attribute approximately 71 bps of the BB rating bucket’s outperformance to the fallen angels and 60 bps to rising stars. The performance of BB rating bucket after accounting for these effects does not stand out.

Conclusion

This analysis highlights the dynamic interplay between rating movements and bond performance within the corporate bond market. The tent shaped returns of rating buckets can be explained by different risk-seeking behavior among investors in the investment-grade and high yield markets.

The BB bucket, positioned on the edge of the investment-grade and high yield buckets, has the best performance among rating buckets. We observe that fallen angels and rising stars play significant roles in shaping the performance of the BB rating bucket. Together, these bonds attribute to around 90% of BB’s outperformance relative to its adjacent rating buckets.

For passive investors, our results suggest:

• Fallen angels have historically offered one of the best opportunity in the overall corporate bond space for unconstrained investors (I38837US or I38842US).
• High yield investors are historically not compensated for high spread risks and long-term investors may consider excluding the lowest rating buckets (I36121US Index).
• Investment-grade investor may benefit by holding the fallen angels for a bit longer after the downgrade (I38845US or I38841US).
• Investment-grade investors are usually compensated for taking additional risks along rating buckets. Hence, those with higher risk appetite may benefit from taking these risks and invest in BBB rated bonds (I00182US Index).

The data and other information included in this publication is for illustrative purposes only, available “as is”, non-binding and constitutes the provision of factual information, rather than financial product advice. BLOOMBERG and BLOOMBERG INDICES (the “Indices”) are trademarks or service marks of Bloomberg Finance L.P. (“BFLP”). BFLP and its affiliates, including BISL, the administrator of the Indices, or their licensors own all proprietary rights in the Indices. Bloomberg L.P. (“BLP”) or one of its subsidiaries provides BFLP, BISL and its subsidiaries with global marketing and operational support and service.