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Fixed Income

Opportunities in High Yield Bonds

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  • Citi’s Global Investment Committee (GIC) has reduced its overweight in US Treasuries down to neutral as yields fall to negligible levels. As financial markets and the global economy rebound from the COVID-19 shock, Citi analysts have increased their desire to move down in quality within corporate credit. The GIC has reduced its overweight in US investment grade (IG) corporates to neutral as yields fall to around 1.25%, and reallocated to US high yield (HY) bonds at a roughly 5% yield. Not only are spread premiums still relatively wide, but lower quality corporates may also help buffer a cyclical rise in risk-free rates.

 

  • In particular, the growth in “fallen angel” (FA) corporate bond issuers has accelerated because of COVID-19. These are issuers that used to be IG, but have been recently downgraded and are usually at the high quality end of the non-investment grade spectrum of fixed income.

 

  • FAs tend to fall in price in the months before the rating downgrade (thus falling into HY) and subsequently improve in price in the months after being downgraded as HY managers purchase the bonds. This tends to leave their bond prices depressed or sometimes oversold. Since the 23 March low in risk assets, FAs have returned 33% through 19 August, outperforming the broader HY market by 800 basis points.

 

  • Looking ahead, Citi analysts believe that the impact of COVID-19 on the credit market has yet to be fully felt. While the Federal Reserve is providing ample liquidity and support for troubled companies, future downgrades may be unavoidable and thus a larger pool of potential FAs. However, one risk to consider is concentration risks as certain credit cycles may impact particular sectors more than others. In 2015-16, the FA exposure to energy bonds grew to 25%. Currently, the majority of FAs are from the auto, leisure, lodging and energy sectors. As such, FAs may be used as a complement to diversified HY strategies.

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