Introduction
Convexity in corporate credit is the balance between upside and downside price potentials. As a crucial factor in high-yield portfolios, a favorable convexity can play a significant role in delivering superior performance. While the math is straightforward, the challenge lies in effectively improving the convexity of a high-yield portfolio.
Convexity of Newly Issued High Yield Bonds:
Newly issued high-yield bonds often exhibit unfavorable convexity. Their upside price potential is constrained due to shorter maturities and the possibility of early redemption by the issuer. Over the past decade, non-call periods have shortened, and call premiums have reduced, further limiting the upside. These bonds can have a mere 5-10 points of upside potential while risking 60-70 points in a default situation.
On the other hand, newly issued investment-grade corporate bonds possess better upside due to their non-callable nature and sometimes longer maturities, extending up to 30 years or beyond. Newly issued loans, however, may have limited upside, especially if they are callable at par after a short initial period.
Current State of High Yield Convexity
The post-Global Financial Crisis (GFC) period saw the US high-yield market predominantly trading at or above par, except during the late 2015-early 2016 energy slump and the initial months of the 2020 pandemic. The recent trend of the high-yield index trading below 90 cents on the dollar has improved its convexity. Instead of the traditional 5-10 points of upside, bonds may now offer 15-25 points, with a reduced downside risk estimated between 50-60 points.
Optimizing Positive Convexity
It’s not just about purchasing at a favorable price; an understanding of bond structures and fundamental analysis is paramount. Investing between 70-90 cents on the dollar can yield positive results, provided the risks of excessive defaults and illiquidity are minimized.
A primary objective is identifying bonds more prone to upside surprises than downside shocks. These surprises could stem from acquisitions, refinancings, or company tenders at higher-than-market prices. On the contrary, decisions that shift value away from your bonds or poor capital allocations can lead to adverse outcomes.
Exploring Convexity Beyond High Yield Bonds
Dedicated high-yield managers might face challenges in introducing positive convexity to their portfolios. When seeking to improve the credit quality of their portfolios, they might overload on BBs, the high-yield market’s premium credit quality. Such an approach can lead to reduced upside potential and overvaluation, which isn’t a true defensive strategy.
To achieve optimal convexity, managers need the leeway to exploit adjacent asset classes. BBBs, the lowest credit quality in the investment-grade corporate bond market, can be attractive when BBs aren’t. These BBBs often have better upside potential because they’re non-callable. Sometimes, bond ratings can have an inverse relationship with spreads. While individual bond analysis is crucial, some BBBs might provide better potential and valuation than BBs.
Another potential advantage of BBBs is the ability to introduce duration to the portfolio without a significant risk of credit spread volatility. Adding duration to a portfolio with select BBBs is more sensible than with overvalued BBs.
Convertible bonds also present opportunities for better convexity. “Busted convertibles,” characterized by near-zero coupons issued when stock prices were high, could offer significant upside with limited downside.
Conclusion
Positive convexity in high-yield portfolios is more attainable now than in much of the post-GFC era. To maximize favorable outcomes, it’s essential to have a deep understanding of bond structures and fundamental analysis. The flexibility to explore adjacent markets, like investment-grade and convertible bonds, can be an invaluable asset for high-yield portfolio managers.
Note: The mentioned indexes like ICE BofA US High Yield Index and others track the performance of specific segments in the US bond market.
