Crossover bonds – the bond issues situated between investment grade and the high yield space – can be an ideal area to find alpha opportunities, says Matt Eagan, Co-Head of Loomis, Sayles & Company’s Full Discretion Team. With decades of experience investing within the crossover bond area of the bond market, he explains the team’s distinct process for pinpointing ideas throughout the credit cycle and what areas look more favorable today, in this April 2023 interview.

How does the Loomis Sayles Full Discretion Team’s process stand out in the crossover space?
Eagan: I really think our reputation was built upon our very strong capability of capturing value in that BBB to BB portion of the bond market – where we believe so much alpha can be generated. This is the part of the market where we find many of our Fallen Angels (see Figure 1) and Rising Stars ideas. These bonds can go through big category shifts in the marketplace and lead to a lot of volatility, which is ideal for bond pickers like us.

About our investment framework and process: We use a bottom-up security selection perspective across all of our strategies that focus on six investment pillars. Three of them relate to this notion of investing in the crossover credit space of BBB to BB. We call them Fallen Angels, Upgrade Candidates (Rising Stars), and Cheap for Rating.

Figure 1: Six Pillars of Security Selection

Fallen Angel: Forced selling by investment grade accounts pushes bonds below fair value and inflates risk premium.
Cheap for Rating: Bonds trading cheap to fundamental credit risk tend to outperform.
Upgrade Candidates: The market is often slow to price potential upgrades due to short time horizons and distortions created by passive investing.
Stressed/Distressed: In our experience, prices for the lowest quality bonds become severely dislocated when the distressed ratio is elevated.
Avoid Losers: Avoiding permanent principal losses associated with value traps can add significant alpha.
New Issue Premium: New issues often come at a premium in order to attract investors to the primary market.
Focusing on Fallen Angels, we systematically track and follow this area because our research has shown that Fallen Angels tend to outperform BBBs and even high yield by a significant amount over the cycle. If you can pick the right names within this area, you have the potential to add even more value. Why is that? Well, in some cases you have investment grade-only buyers who can only stay in the investment grade area. So, when a bond is in danger of moving to non-investment grade, they have to sell. They're force sellers. Oftentimes, we'll buy before the bond is downgraded. We make sure we understand where it's going to land within the high yield market and make sure it's a stable credit story that can get through whatever issue is driving the current negative credit rating trends.

By the way, these credits tend to happen in droves during an economic downturn. We witnessed this in 2020 during the pandemic-driven downturn. We were able to pick up a lot of names for our portfolios at that time.

Next, as the economy starts to come out the other side, you get the Rising Stars. Oftentimes those names are former Fallen Angels. But they can also be companies coming out with original issues in the high yield market. So that's another area where you have potential to generate value with significant spread tightening over time and over multiple years.

Lastly, Cheap for Rating is just what we do very well as bond pickers. We have an experienced research team that understands where the credit ratings may be headed, in some cases two to three years out in time. Also, we believe we are early at identifying those trends. This enables us to buy them at attractive prices and watch them get upgraded.

What do you think of crossover bonds in today’s landscape?
A lot of people are still a bit on the sidelines. They think there is a recession coming and are concerned about what will happen next. So they are waiting it out. From our viewpoint, the market is a discounting machine. We also think that there is a downturn coming. But looking at all of the economic data, we believe there is going to be a relatively mild recession.

A recession is pretty much base case in the market. Not surprisingly, when you distill what you're being paid for in the spread, what we call risk premium in the market, you already are getting compensated for the level of losses that the market foresees coming over the next year or so. And where might those losses come from? In the investment grade area, there are those downgrades that you see and maybe some Fallen Angels. I don't think there's going to be a ton of Fallen Angels during this downturn compared to past downturns. Nonetheless, we expect to see some coming our way. We also think there are probably some more Rising Stars still working their way up in 2023.

Then on the high yield side, we may potentially see not only downgrades emerge, but also losses given defaults. Our corporate health indicator at Loomis Sayles, which we have used to evaluate the health of the credit markets for quite a long time, is telling us that corporate credit fundamentals are the best they have been this late in the cycle. In fact, it is the best I have seen in my 20-plus-year career. Why is that? A lot of companies’ profitability margins have been very strong. Their interest coverage is strong because they have locked in their financing at very low coupons. That will get refinanced over a period of time. But for a long time, they will have locked that in. And for a long time the Fed was very easy, credit was easy, and interest rates were historically low. So the setup is that fundamentals are strong.

What might the downturn mean for defaults?
Let’s take the high yield area for example: When we forecast out actual levels of losses and defaults coming through the system, we don’t expect much more than 3% to 4% losses. That is looking at both our model defaults forecast, which has historically been quite accurate, and a bottom-up screen from our industry analysts on single bonds. Then we look and compare that with what is priced into the market, or what is embedded into the spreads, with high yield around 500 basis points. So, when you think about potentially losing as much as 300 basis points from losses, you are still getting an excess of 200 basis points baked into your spread over a one-year period and then over multiple periods.

Are there value opportunities within individual names?
Yes, we think this is where it gets interesting. Because, when you start looking below the surface, the value that is there is what really excites our team right now. This is including the BBB and BB into the high yield market. We see two things driving this value opportunity. First, this is the lowest discount market I've seen in perhaps my entire career in a non-distressed market. So there are discount bonds all over the place. In high yields we are seeing $0.60, $0.70, $0.80 discounts to the dollar. In investment grade, $0.80 or $0.90.

Now, a lot of that has to do with just the coupons being low, so we must keep that in perspective. But still, it means that you have a pretty good margin of safety for investing in the marketplace. It also probably means spreads aren't going to really blow out very much wider because at the end of the day, for a fixed income investor, you have safety in the recovery value of the bond in the worst possible case.

This is important because it drives convexity in the market. And as a bond picker, if you select a variety of bonds, and one or two get upgraded, that bond has all that way to run to par. Therefore, it has the potential to generate significant total return and excess return. Overall, we believe it is a good time to be a bond picker.
All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided. Investors should fully understand the risks associated with any investment prior to investing.

BBB to BB refers to a bond’s credit quality rating by rating agencies S&P and Fitch. Bonds with a BBB or higher are considered investment-grade. Bonds with lower ratings, such as BB, are considered non-investment grade (also called high yield) and have a higher likelihood of failure to repay their debts.

Alpha is considered the excess return an investment produces compared to a benchmark index.

Coupon refers to the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity.

Convexity is apparent in the relationship between bond prices and bond yields. Convexity is the curvature in the relationship between bond prices and interest rates. It reflects the rate at which the duration of a bond changes as interest rates change.

Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity.

Below investment grade fixed income securities may be subject to greater risks (including the risk of default) than other fixed income securities.

Credit quality reflects the highest credit rating assigned to individual holdings of the Fund among Moody’s, S&P, or Fitch; ratings are subject to change. The fund’s shares are not rated by any rating agency and no credit rating for fund shares is implied. Bond credit ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest).

Interest rate risk is a major risk to all bondholders. As rates rise, existing bonds that offer a lower rate of return decline in value because newly issued bonds that pay higher rates are more attractive to investors.

This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Natixis Investment Managers, or any of its affiliates. The views and opinions are as of April 21, 2023 and may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted, and actual results may vary.

Natixis Distribution, LLC is a limited purpose broker-dealer and the distributor of various registered investment companies for which advisory services are provided by affiliates of Natixis Investment Managers.

Natixis Distribution, LLC (fund distributor, member FINRA | SIPC) and Loomis, Sayles & Company, L.P. are affiliated.