Market Stress Hits High Yield Bonds
The European CCC index offers a spread of 1,306 basis points over government bonds, which may seem like generous compensation for taking credit risk. However, this spread is deeply misleading, as it combines two very different groups: performing companies and distressed companies.
Performing vs Distressed Companies
Performing CCC bonds, defined as those trading below 1,000 basis points, offer a spread of 438 basis points, which is tight by historical standards. These companies are expected to continue servicing their debt, but investors still face meaningful default, downgrade, and liquidity risk.
The aggregate CCC spread combines conventional spread assets with potential recovery assets, making it a poor guide to the compensation available on performing CCC risk. Above 1,000 basis points, the analysis for a bond changes, and the outcome and timing of a potential restructuring dominate the price of the bond.
Related: Emerging Markets Still Worth Investing In
Distortion in the Market
The distortion extends beyond CCCs, as a relatively small number of distressed bonds can have a disproportionate effect on the average spread. These securities record extremely high spreads, even when spread is no longer the most useful way of valuing them.
CCCs account for only 4.3% of the European high yield index, but the presence of distressed bonds pushes the average spread above the level available on most performing bonds. The gap between the mean and median illustrates the effect, with the median spread giving a better indication of spreads for a typical bond.
At present, the headline mean index spread of 244 basis points suggests that European high yield offers reasonable compensation, while the median spread of 169 basis points suggests that the typical performing bond is priced much more aggressively.
Most investors treat the index spread as a quick read on value, but it isn’t always accurate. When distressed bonds contribute an outsized share of that spread, the headline flatters the performing market that makes up the bulk of what you can actually buy.
Related: Credit roll-down strategy gains traction
Reading the Market
The lesson is to read the market through the median, the spread distribution, and the share of bonds trading at distressed levels, not a single average that a small tail can distort. For performing CCCs, the only consideration that matters is whether 438 basis points pays for the default, downgrade, and liquidity risk you are taking versus a single-B.
It’s a matter of understanding that the real risk is not always distress, but rather paying too much for the credits that avoid it.
Most investors treat the index spread as a quick read on value. In the end, investors need to look beyond the headline numbers and focus on the market’s characteristics to make informed decisions.
