Don’t overthink default risk

Investors shouldn’t avoid the high-yield space due to fear of default risk, says Nicholas Leach, vice-president of global fixed income at CIBC Asset Management.

“Many investors think the default experience [in high-yield] is simply too high for their risk appetite,” Leach explains. But, “when we look at the high-yield credit markets, there are three large credit categories of risk: the higher-quality double-Bs, the mid-quality single-Bs, and the lower-quality triple-Cs.”

Leach, who’s lead manager of the Renaissance High-Yield Bond Fund, adds that triple-C names make up only 14.5% of the high-yield sector, but are responsible for between 80% and 85% of defaults.

“If we go back over the last 30 years, since record keeping started, the default rate for triple-C bonds is 14% [and] the default rate for double-B bonds is 0.79%,” says Leach. “Arguably, these two credit categories are separate asset classes because their default experience is so dramatically different.”

Read: Why companies issue high-yield bonds

Leach’s portfolio is overweight double-B-rated companies, which he says are stronger and more liquid. Further, since he’s committed to the higher-quality area of the credit curve, he says, “We’ve actually removed triple-Cs from our benchmark, and that really reduces the incentive for us to venture down into that space. This should position us very well for 2017 in the event of a turn in the credit cycle.”

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High yield or investment grade?

Higher-quality companies in the high-yield space tend to be the large-cap companies, says Leach, pointing to “those companies with critical mass [and] those companies that have market dominance. They’re [most often] in industries that have very stable and growing revenues.”

One such name is T-Mobile U.S., a telecom provider south of the border. “This company is actually very close to being investment-grade. The reason it’s not is because it went out and bought a [lower-quality] competitor,” bringing its rating down. “So, in a way, this company is rated double-B by choice.”

Read: Don’t underestimate high yield

This is a common theme in the space, says Leach, especially among his double-B picks. “For one reason or another, whether it’s to make an acquisition or spend the capital to upgrade, [companies will] take on a little bit more debt.” As a result, they remain high-yield versus investment-grade.

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