Investors find value in crossover trades
April 12 (IFR) - With one foot in investment grade and the other in high yield, split-rated bonds could prove a lucrative buy for investors with the flexibility to trade around the market's unique technicals, industry experts say.
The crossover segment of the credit market has enjoyed a strong run over the last couple of years. Not only has triple-B paper gained relative to the rest of investment grade because of investor preference for high-beta products, but double-B bonds held their own for much of 2012 as declining Treasury yields supported valuations, says Michael Anderson, chief high-yield strategist at Citi.
"The investment grade/high yield cliff is the most important in the credit universe because rating changes across these segments often require index transitions," says Anderson.
Such index transitions also mean an important shift in the investor base.
"Investors who are able to efficiently trade around these technicals can pick up valuable relative performance."
Two borrowers in the US have sold split-rated deals this week, including discount store Dollar General, which purportedly garnered demand of more than USD4bn for its USD1.3bn dual-tranche 5- and 10-year offering.
The deal's success came despite a five-B split rating which broke some investors' investment guidelines and prevented them from participating.
"It's the up in quality trade for those that prefer double B trades and it's the tail end of the risk spectrum for most of the high grade market that looks at the triple B space," explains Andrew Karp, managing director and head of investment-grade bond syndicate at BoA Merrill.
With a coupon of just 3.25% for the USD900m 10-year tranche, the deal did not see much participation from investors in the high-yield market, where the average coupon is 7.69%, according to the Barclays Capital US High Yield Index.
It was, however, attractive to investment grade buyers for a couple of reasons: few high-grade investors have exposure to the credit, and its credit trajectory is positive, so you are getting into the name at a good point.
"When there is a trend for compression of spreads across the rating spectrum is when we tend to see the best appetite for crossover type names, and that certainly has been the case in this recent market," says BofA Merrill's Karp.
But with fund flow firms typically only tracking flows from funds with dedicated mandates for high yield or investment grade, measuring such crossover flows is no easy task.
Last month, Moody's upgraded the company's senior unsecured rating to Baa3 from Ba2, citing strong operating performance and the company's market position as the largest dollar-store chain.
Dollar General is rated BBB- by Standard and Poor's, which assigned a speculative-grade rating of BB+ (watch positive) to the issue.
According to Anderson, there have been 26 rising stars since 2010 with a total of US58bn par amount outstanding, with Ford's upgrade in 2012 representing 40% of the total.
However, an upgrade to investment grade doesn't always guarantee an outperforming bond, says Citi's Anderson.
"Upon news of the upgrade, Ford spreads surprisingly widened.
"We suspect that many added Ford to their investment grade books ahead of the upgrade, and once the news was out, the bid for paper waned."
Anderson adds that with corporate spreads and yields narrowing in response to overwhelming monetary liquidity from the Fed and a strong fundamental backdrop, combining credit analysis on potential rising stars and fallen angels with an understanding of the crossover technicals can lead to significant performance benefits.
The 10-year Dollar General tranche tightened in around 30bp from its launch spread of 155bp over Treasuries by Wednesday's close.
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