Finding Alpha Opportunities in Corporate Bonds
June 17, 2021
Read Time 5 MIN
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Investing in the most attractively valued bonds, and avoiding bonds that are overpriced, can be a compelling strategy for investment grade corporate bond investors to earn an attractive yield without taking on too much risk. But for any strategy to be effective, an issuer-by-issuer, bond-by-bond analysis is required. The U.S. investment grade bond market is vast and diverse, and bucketing securities by broad metrics like credit rating and duration is simply not granular enough to provide a basis for valuation analysis. Consider that there are over 4,800 BBB rated bonds alone (52% of the broad market), from over 840 different issuers across all sectors.1 Knowing a credit rating is not enough to determine whether a bond may provide attractive value. In addition, a rating is not forward-looking or responsive to market-based information, and so does not provide an adequate basis to base security selection decisions on.
Instead of traditional measures like credit ratings, we rely on the industry-leading credit model developed by Moody’s Analytics to identify attractively valued bonds that may provide upside potential. More information on the Moody’s Analytics credit model can be found here: Smarter Approaches to Corporate Credit. We illustrate below how a key output of the model, the fair value spread, is used to identify relative value opportunities in the marketplace as they arise. The fair value spread is the compensation that investors should demand to hold a bond, based on the model’s assessment of prospective risk. Any difference between market pricing and fair value represents a market mispricing of risk: either a bond is “cheap” and attractive, or “rich” and should be avoided.
In the below example, five bonds with several common traits are highlighted: all are rated BBB-, all have approximately five years to maturity, and all have at least $1 billion of par amount outstanding. From a rating, duration and liquidity perspective, these bonds are all similar. However, there is clear differentiation from a risk perspective when viewed in the context of their fair value spreads (the difference between fair value and market price). Differences in sectors account for some difference, but these different fair values are also driven by the underlying credit risk of these bonds. In this example, the BNP Paribas subordinated bond issue and the Time Warner bond appear to offer attractive value. An investor benefits by earning substantial excess spread over fair value. In other words, these bonds are undervalued by the market, and investors are earning more compensation for lower risk. Over time, if the market recognizes this mispricing and spreads begin to tighten towards fair value, bond prices will move upwards, all else equal, providing additional upside to investors.
Relative Value of Corporate Bonds Not Driven Only by Rating, Size or Maturity
Selected BBB-, 5 Year, >$1B Bonds, as of 5/31/2021
Source: Moody’s Analytics, ICE Data Indices and VanEck, as of 5/31/2021. This is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein. Market spread is a bond’s credit spread based on current market prices. Alpha opportunity is when there is positive excess spread (the excess of a bond’s market spread over the fair value spread, representing potential mispricing and upside potential). Overvalued is when there is negative excess spread.
On the other hand, bonds such as the ones issued Enterprise Operating LLC, and to a lesser extent Sabine Pass Liquefaction, appear overpriced. The market price is insufficient to compensate investors for the embedded risk of these bonds, based on the model’s assessment of risk and value. Note that the Enterprise Products Operating LLC bond has a market spread that is much higher than what can be earned by holding the Time Warner and Societe Generale bonds. Nevertheless, investors may not be earning adequate compensation for holding these bonds, and there may be downside risk if market pricing adjusts to reflect fair value.
Analyzing bonds through the lens of fair value allows investors to buy undervalued bonds and avoid overpriced bonds.
To further illustrate the dynamic nature of these mispricings, an additional example is shown below, representing both the market spread and the fair value spread over six months for a bond issued by Las Vegas Sands. The gap represents excess spread. Las Vegas Sands, like other issuers in the Gaming industry, was particularly impacted by the pandemic-driven selloff and market spreads widened relative to the model’s fair value. As shown in the chart, the excess spread has gradually dissipated over the past six months as market spreads have tightened significantly, benefitting holders of this bond, while fair value spread has remained relatively constant. Because only bonds with the highest excess spread are eligible for inclusion, this bond left the MVIS Moody’s Analytics US BBB Corporate Bond Index in March 2021.
Moody’s Analytics Credit Model Seeks to Capture Market Mispricings
LVS 3.5 8/18/2026
Source: Moody’s Analytics, ICE Data Indices and VanEck. This is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein. OAS is market spread. FVS is fair value spread.
The above example illustrates that fair value is dynamic, and that an investment strategy based on finding attractively valued bonds must be responsive in order to capture market mispricings when they exist. The Moody’s Analytics model uses market-based information, including the issuer’s stock price, to develop a forward looking assessment of credit risk. The MVIS® Moody’s Analytics® US Investment Grade Corporate Bond Index and the MVIS® Moody’s Analytics® US BBB Corporate Bond Index use this data to identify the most attractively valued bonds, and both are rebalanced monthly.
The VanEck Vectors Moody’s Analytics IG Corporate Bond ETF (MIG) seeks to track, as closely as possible, before fees and expenses, the price and yield performance of the MVIS® Moody’s Analytics® US Investment Grade Corporate Bond Index, which includes investment grade corporate bonds that have attractive valuations and a lower probability of being downgraded to high yield compared to other investment grade bonds. VanEck Vectors Moody’s Analytics BBB Corporate Bond ETF (MBBB) focuses on the BBB rated segment of the market and seeks to track, as closely as possible, before fees and expenses, the price and yield performance of the MVIS® Moody’s Analytics® US BBB Corporate Bond Index.
1 Source: ICE Data Indices as of 5/31/2021
This is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. The information herein represents the opinion of the author(s), but not necessarily those of VanEck.
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