A First For The High-Yield Market

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Summary

The BB segment of the high-yield corporate bond market is trading with negative convexity for the first time in its history.

This article discusses convexity, and the drivers of the current negative convexity of the high(er) quality segment of the high-yield bond market.

Given the tremendous amount of retail flows into what traditionally has been an institutional market, I wanted to share some thoughts on this phenomenon to new potential investors in HY.

As an early disclaimer, this may be a little bit of an esoteric topic and too "mathy" for some readers, but I think the implications for high-yield bond investors are important to understand. Given the global reach for yield, retail money has flown into junk bond funds and popular high yield exchange-traded funds (HYG, JNK), and investors might not fully appreciate the market's changing risk-return profile. A risk measure in the high-yield bond market is flashing a signal that it is unique in its history, impacting the risk-reward profile of a large segment of the market.

That risk signal is the current convexity measure. As the graph below shows, the convexity of the BB segment of the high-yield bond market is negative for the first time in its history.

Click to enlarge

What is convexity? Convexity is the measure of the curvature in the relationship between bond yields and bond prices. This measure demonstrates how the duration of a bond changes as interest rates change. If this was calculus class, it would be explained in the following terms. Duration is the first derivative of the price-yield function, and convexity is the second derivative. Both are needed to understand precisely how a change in rates will affect the price of a bond.

We know that when interest rates fall, bond prices typically rise. For non-callable securities like Treasury bonds, falling interest rates has been a boon, especially for long duration bonds whose prices have increased strongly in a lower rate environment. Treasury securities have positive convexity, and as we saw in A Bond Market Lesson, durations have extended as yields have fallen.

Positive convexity has contributed to gains for bonds, but why is negative convexity bad? The easiest example to describe negative convexity is the market for Agency mortgage-backed securities. Imagine you have a pool of mortgages with an average coupon close to the prevailing mortgage rate. The bond trades roughly at par. If mortgage rates were to rise, the bond would fall in value due to its duration and the inverse relationship between bond prices and bond yields.

If mortgage rates were to fall, the bond would rise in value, but its gains would be less limited than the losses in the higher rate scenario. Why? All of the underlying mortgages in the pool have a prepayment option. Homeowners can opt to refinance at the prevailing lower mortgage rate; bondholders get back principal back at a time when non-callable bonds are rising in value and reinvestment rates are lower.

Duration has a dual meaning in finance. It is a bond's sensitivity to changes in rates and the weighted average timing of cash flows. In the higher rate scenario, the mortgage-backed security is extending. as prepayments are less likely as rates rise. In the lower rate scenario, prepayments are more likely as homeowners reset their mortgage rate lower. Convexity describes this relationship.

High yield bonds also typically have optionality. Lenders grant the right to call the bond at typically sliding premiums above par after a pre-defined non-call period. The borrower likes this option because it allows them to reset their borrowing rates lower as their credit profile improves without waiting for the bond to mature. Lenders in speculative grade markets like a credit with an improving credit profile.

A high-yield bond has negative convexity when it is trading above its call price. On average, BB bonds are now demonstrating a negatively convex profile. The average bond price of BB bonds is $104.38, producing a yield-to-worst of 4.40% at an average spread of 302bp over matched Treasuries. Pre-crisis, when the Fed Funds Rate was at 5.25%, you could earn this yield in your savings account, but now must lend to junk companies to generate the same yield.

It is not uncommon for lower rated credits to trade with negative convexity when market spreads are tight and these issuers are getting a chance to refinance their relatively higher coupons at lower market rates. It is a historical anomaly for BB-rated credit to have a negatively convex profile. That is because investors in BB credit are willing to trade the lower credit risk in BB-rated credit for lower coupons and offer lower credit optionality to refinance.

Historically, this has been a very favorable tradeoff for investors. As I demonstrated in "The Low Volatility Anomaly: A High Yield Bond Example," BB-rated bonds have produced higher returns on both an absolute and risk-adjusted basis as compared to B and CCC-rated bonds. Over the life of the high yield bond market, on average, investors have not been paid for going down in credit risk.

This negatively convex profile for BB credit means that we have approached the limit to how much more BB bonds can rally as their price moves above the average call price. Investors seeking higher returns can move down in quality to bonds offering wider spreads. The credit spreads of high yield bonds exhibit momentum. In the short run, investors can probably eke out incremental returns by going down in quality and riding the momentum wave, but longer-term lower-rated credit has typically not provided enough compensation for default risk.

The negative convexity of BB-rated credit means there is no place to hide in high-yield credit, and investors should consider reducing their allocation to the asset class. The market will provide an opportunity to re-enter at wider yields.

Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore, inherently subject to numerous risks, uncertainties, and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.

Disclosure: I/we 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.