As the business cycle gets long in the tooth, the quality of the investment-grade index has declined relative to a decade ago. The proportion of lower-rated/lower-quality BBB-rated bonds has steadily risen from 36% of the U.S. Investment Grade Corporate Bond index in mid-2007 to 49% through June 2017, according to Bloomberg Barclays. High-yield credit is also always fraught with risk. In contrast to investment-grade bonds, investors are not usually rewarded when they dip down to the lower-quality segments of the high-yield market, because any perceived advantage tends to be offset by more volatile bond prices. This can lead to comparable or lower average total returns due to significantly higher volatility associated with the lowest-quality segment of the high-yield market. And when markets sell off, high-yield bonds tends to react more like equities than low-volatility bonds and are vulnerable to downside risk.
Exhibit 3 depicts the loss-adjusted spreads by rating cohort. In CCCs, the lowest-rated issues in the high-yield market, the loss-adjusted spread is currently negative when historical losses are taken into account. While the return profile of CCCs argues against a strategic allocation over time, this segment of the market displays greater dispersion of returns than that observed within the other portions of the high-yield market (BB- or B-rated issues), suggesting that opportunities exist to add value with prudent security selection. Also, CCCs often outperform after significant sell-offs in credit risk, when spreads have widened to attractive levels, with sharp recoveries ensuing.