The No-Default Fallacy Of CCC Corporates

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In the high-yield market, it’s no secret that the lower a bond’s quality, the higher its risk of default. Here’s something that isn’t so well understood: low-quality bonds can damage a portfolio even before they default.

Investors often tell us they chose a particular high-yield strategy because over time it suffered very few defaults—or none at all. But when these strategies include a large share of CCC-rated “junk” bonds, the statistics probably don’t tell the whole story.

CCC Corporates

That’s because with distressed bonds, the steepest price declines usually come well before an actual default (that’s true of more highly rated bonds, too). Now, it’s certainly possible for managers to unload a bond at pennies on the dollar and say their portfolios avoided a default. What they can’t say is that they avoided losses. By selling at a steep discount, they’ve actually locked in losses, no matter whether the issuers ended up defaulting or not.

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What’s more, it isn’t always obvious when a company is headed for trouble. Sometimes, markets anticipate default well in advance. Other times, a company’s fortunes go south much the way Ernest Hemingway said a man goes broke: “gradually, then suddenly.” Strategies that invest heavily in the lowest-quality corporate bonds have a higher risk of being blindsided.

CCCs Soared in 2016, but May Crash This Year

Now, it’s true that in 2016, owning the lowest-quality corporate bonds actually paid off. The annualized return for this part of the market was about 30%, nearly double that of the broader US high-yield market. The outsize gains were mainly thanks to commodity prices, which stabilized last year after a sharp 18-month decline, helping troubled energy-sector bonds rebound.

But betting on a repeat performance is, in our view, akin to playing Russian roulette. For one thing, the odds are heavily stacked against it. According to Moody’s Investors Service, CCCs logged an average default rate of more than 11% between 1994 and 2015, compared to 2.8% for B-rated securities.

What’s more, CCCs simply don’t have much room to rise further. The average dollar price in the sector was $67 when 2016 began; today it stands around $86. That’s historically high for the lowest-rated, highest-risk sector of the high-yield market.

As US interest rates continue to rise, we expect conditions in 2017 to get even more challenging for companies in distress. Rates are lower in Europe, where it’s earlier in the credit cycle. Even so, we think it pays to steer clear of CCCs. Are there occasionally unique opportunities in this part of the high-yield market? Sure. But finding them requires exte