To Keep Bad Spirits At Bay, Avoid CCC Corporates

To Keep Bad Spirits At Bay, Avoid CCC Corporates

To Keep Bad Spirits At Bay, Avoid CCC Corporates by Gershon Distenfeld, AllianceBernstein

Investors attempting to hide from rising rates by choosing investments with significant amounts of CCC-rated corporate bonds could be whistling in the dark—and exposing themselves to a more ominous kind of risk.

As the US Federal Reserve makes plans to raise interest rates, many investors fear the fallout on their fixed-income portfolios. But trying to avoid interest-rate risk by investing in funds with an abundance of CCC-rated corporate bonds—the riskiest part of the high-yield bond market—may not be a sensible alternative.

Beware Credit Risk

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While it’s true that CCC bonds have little to no interest-rate risk, what has an even more terrifying effect on a portfolio is credit risk, or the chance of a bond defaulting. Interest-rate risk, on the other hand, may be resolved over time, as portfolios tend to bounce back after a while.

When it comes to high yield, CCC-rated bonds can look enticing, but it’s usually best to steer clear of them. Their higher yields are a lure to investors—and we occasionally do see opportunities in that part of the market. But as we’ve been saying for some time, the rewards seem too little to justify the risk.

So far in 2015, CCCs are down 6.5%, while BB-rated bonds are up 1%. And on a risk-adjusted basis, CCCs look unattractive. After adjusting their yield spreads by the expected default losses, CCCs and lower-rated bonds actually offer lower yield premiums than B-rated bonds—and about the same as BB bonds, which have much less credit risk (Display). We expect this environment to continue as we move into the later stages of the credit cycle, because highly levered companies are likely to come under even more pressure.

All things considered, we see better value in bonds rated B and BB these days. Investors may sacrifice some nominal yield by investing in these issues, but they’d also scale back their risk. This may not sound like an attractive compromise to some, but when you consider that there’s greater potential for a credit scare, this approach starts to make more sense.

Don’t Get Caught in the CCC Web

We think a global, diversified approach to credit is a better strategy for investors, and B and BB bonds should be a part of it. When considering credit investments, make sure to ask a straightforward question: Am I going to get my money back? For select CCC-rated bonds, that answer might make an investment worthwhile. But in general, the answer is likely to be, “I’m not sure.” If that’s the case, don’t be tempted by the possibility of extra CCC yield. The results could be frightening.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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