Over the past year, a surge of investors drove high-yield bond prices back to pre-pandemic levels. By many measures, high-yield bonds now appear expensive. But a wave of rising stars—bonds moving to investment-grade ratings from below investment grade—may signal that there’s more happening in credit markets than meets the eye.
Credit Is Primed for Upgrades
As the country went into lockdown, credit markets braced themselves for a wave of fallen angels—investment-grade credits dropping to high-yield ratings. But as the dust settles and the economy rebounds, catastrophic assumptions have proven too extreme. We believe this has started an upgrade cycle in credit markets.
Potential rising stars have attracted attention, partly because credits reaching investment grade have a much larger base of potential buyers, providing meaningful future price support. But all credit improvements are material—whether it’s a rising star or an upgrade from CCC to B, and regardless of whether recognized by rating agencies or just by market participants. Why? Because credit improvement generally leads to rising bond prices.
The earlier an investor can ferret out and buy an improving credit with a potential upgrade on the way, the better. As more and more investors believe a bond is approaching a rating upgrade, they bid up the price ahead of time, compressing the bond’s yield spread over investment grade. Most of that spread compression happens before the upgrade (Display).
For some investors, such as insurance companies, the ability to identify BB-rated bonds primed for an upgrade can bring significant additional benefits. Insurance companies are sensitive to the credit rating of bonds they purchase due to capital requirements, so they usually strictly limit their high-yield holdings. But if they can identify BB-rated bonds destined for an upgrade early on, they get to book the higher yields, realize the price appreciation and get better capital treatment after the upgrade. The potential for a double dip should increase insurance companies’ appetite for juicier high-yield offerings.