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Global markets have been historically tumultuous over the last several years as the Great Recession extended into the European Sovereign Debt Crisis. Investors seeking market safe havens have pushed the yields on traditional flight-to-quality instruments, like U.S. Treasuries (NYSEARCA:GOVT), to record low rates. As investors search for palatable investment returns, while keeping a wary eye on remaining market uncertainties, this article discusses an investment subset of the fixed income universe that has historically produced greater returns than other riskier market segments.

Over the last generation, capturing the entirety of the modern speculative grade or "junk" bond market, BB-rated corporate bonds have outperformed their lower rated counterparts on an absolute return basis due to their lower rate of default. An asset subsector providing higher absolute returns for lower variability of returns presents Seeking Alpha's long-term investors the chance to generate alpha in the higher quality segment of the high yield bond universe. Below are annual total returns of the Barclays Capital U.S. High Yield index subdivided by ratings strata.

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The return profile above demonstrates that although the lowest rated bonds (CCC) have had more than twice the variability of annual returns as compared to the highest rated below investment grade bonds (BB); they have still failed to keep pace with the returns of the higher quality instruments. If you have seen your portfolio whipsawed by the events of the last several years, higher average returns with lower risk will certainly be appealing. Examining loss rates by ratings category over a matched time horizon illustrates why BB-rated bonds have outperformed - investors have experienced much lower credit losses historically on BB-rated bonds.

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Examining the lowest ratings cohort in the bottom of the investment grade universe (Baa under the Moody's nomenclature; BBB by Standard and Poor's and Fitch) versus the highest ratings cohort in the top of the speculative grade universe (Ba or BB) demonstrates that the increase in credit losses moving down in relative credit quality from Baa bonds to Ba bonds is minimal historically. This 55 basis point uptick in average annual credit losses is less than even the tightest spread differential between Baa and Ba bonds in the historical dataset, demonstrating that investors are always compensated for this incremental credit risk in terms of annual expected credit losses. (All spread information in this article is from the benchmark Barclays Capital credit indices). The average spread differential of 180 basis points between Baa-rated bonds and Ba-rated bonds is more than triple the average incremental annual credit losses. The current differential of 143 basis points (Ba-rated corporate bonds have an option-adjusted spread of 321 basis points versus Baa-rated corporate bonds' OAS of 178) would have proven ample compensation for the differential in realized credit losses between the two ratings cohorts in the Great Recession.

Investors over a long holding period have not historically been compensated on a loss-adjusted basis for moving down in credit risk between Ba-rated bonds and B-rated bonds. The 174 basis points in average spread pickup is equal to the increase in average annual credit losses, but less than the 205 basis point median difference with that difference diverging sharply in times of market stress. The current 133 basis point spread differential may provide appropriate incremental compensation to investors over the near-term due to continued expectations of low near-term default rates, but is not sufficient compensation to offset the higher average annual credit losses (an incremental 229bp) expected on these bonds over a longer horizon.

While relative value between B-rated bonds and BB-rated bonds may not be overly compelling in a historical basis, CCC-rated bonds look even more expensive in this historical context. On average, CCC-rated bonds require an additional 947 basis points of spread to offset the average annual credit losses relative to BB-rated bonds, but the market is currently only compensating investors with an incremental spread of 390 basis points on a matched maturity basis. Markets have only provided investors with an appropriate risk premium for CCC-rated bonds during extreme market duress, which is why CCC-rated bonds have underperformed on a total return basis over this long sample period.

Bonds rated BB provide superior returns over a long time horizon. Given the small amount of incremental default risk between BBB-rated bonds and BB-rated bonds, why do these bonds trade at such a relatively wide credit spread? In the institutional market, there are occasionally forced sellers of "fallen angels", bonds that migrate from investment grade to speculative grade. Higher capital charges on lower-rated securities, investment grade only mandates, and financial covenants that limit below investment grade bond holdings for some institutional investors could lead to additional selling pressure on BB-rated bonds that lowers the relative price of these securities. Regulatory frictions at the edge of the investment grade and speculative grade markets for traditional corporate bond buyers like insurance companies could be what drive inefficient (and favorable) pricing of BB-rated bonds.

Investors in high yield bonds and bond funds should understand this historical dynamic and the potential reasons why the market has failed to further reward BB-rated bonds for their low relative default risk within the speculative grade universe. Bond funds will provide current and prospective investors with the ratings composition of the underlying investments. Even a fund that employed 20-25% leverage (borrowed funds used to buy additional BB-rated bonds) would have had historically the same variability or returns as single-B rated bonds, but would have produced an average annual return over three percent higher. This type of leverage is typical in publicly traded closed end funds. Adding this external leverage to lower risk BB-rated bonds as opposed to lending directly to more indebted single-B and CCC-rated companies has historically produced incremental returns for equal or less risk.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: The High Yield Bond Trade For The Long Run