In a surprising turn in the credit markets, riskier bonds are outpacing safer ones, especially during volatile periods. The key driver behind this shift is the growing importance of interest income, or “carry” as it is known in the industry.
As credit funds experience strong inflows, spreads—the premium for holding corporate debt over safer government bonds—have narrowed significantly. With little room left for further tightening, fund managers are turning to riskier bonds, particularly lower-rated and subordinated ones. These bonds typically offer higher coupons, which help cushion the impact of falling prices when interest rates rise.
This shift has proven so powerful that high-yield bonds have outperformed their blue-chip counterparts in recent selloffs, even though the companies issuing these bonds carry a higher risk of default. A similar trend is emerging with subordinated securities, which have been delivering strong returns when adjusted for risk, as measured by the Sharpe ratio. According to Darpan Harar, a portfolio manager at Ninety One, “The lowest-risk assets—sovereign bonds—have been the most volatile, while assets like CoCos, which are subordinated notes issued by banks, have performed well.”
What’s making this trend even more notable is the changing dynamics between riskier bonds and traditionally safe assets. Normally, risky bonds—often referred to as high-beta instruments—tend to underperform during downturns. However, with government bonds under pressure due to fiscal deficit concerns and uncertainty over future interest rate cuts, credit spreads have become less volatile, while risk-free rates have seen more dramatic fluctuations.
“People are starting to realize that credit spreads are not the volatile part now, the volatile part is the risk-free rate. It’s completely turned upside down,” said Flavio Fabbrizi, head of corporate debt capital markets for Europe at HSBC Holdings.
Another advantage of high-yield bonds is their shorter duration compared to investment-grade bonds, making them less sensitive to interest rate changes. A global junk bond index compiled by Bloomberg shows that junk bonds have about half the duration of their investment-grade counterparts, meaning they experience smaller price declines when yields rise.
Despite some turbulence earlier this month, junk bonds have remained relatively resilient. Bloomberg data shows that the worst year-to-date loss for junk bonds through Thursday was just 0.57%, compared to a nearly three-fold greater loss for high-grade bonds, which have struggled to break even this year. European banks’ Additional Tier 1 bonds, the riskiest form of bank debt, have also outperformed their senior bond counterparts.
However, investors are cautioned to be mindful of refinancing risks. As many bonds with low risk premiums approach maturity, there is concern about refinancing costs. Per Wehrmann, a high-yield portfolio manager at DWS Group, warns that investors need to be careful not to pick up bonds that may face refinancing challenges. “Otherwise, it can become like picking pennies up in front of a speeding train,” he said.
For credit managers, the primary defense remains the carry. If the borrower does not default, investors are likely to at least earn the coupon payments, making it crucial to focus on carry when facing potential losses due to yield or spread fluctuations. Harar of Ninety One encapsulates the approach: “Your first line of defense as a credit manager is carry.”
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