Allocating to borrowers based on quantity, not quality, of debt – dubbed by some as the “bums problem” – does not seem to us the optimal starting point for building a credit portfolio. This approach also ignores valuations.

In our view, a more logical starting point may be to focus on relative value – where bond prices are higher than their modelled fair value. The fragmented and under-researched global high yield market, where pricing inefficiencies are persistent, creates structural opportunities for active investors to identify mispriced bonds.

Market complexity creates pockets of value

Each company typically issues one type of common stock, but may have a dozen of bonds outstanding, each with different seniority, duration and covenants, and each priced slightly differently. Many high yield issuers are also unlisted, with patchy or hard-to-obtain financials.

For active credit managers, these nuances provide the raw materials for judging whether any given bond’s spread is generous relative to the issuer’s underlying risk.

For any rating and maturity, the market demands a certain spread. Mapping those points across the investable universe can create a fair-value curve for any given issuer (see illustrative example opposite). A bond trading wider than its curve is offering a higher spread than its fundamental risk warrants and is, in that relative sense, undervalued; the inverse is true too, of course.

This is a relative judgement, not an absolute one. For example, a solid ‘BB’-rated bond whose spread has overshot can offer better value than a higher-spread ‘CCC’ trading tight to fundamentals that do not justify it.

Read the full ‘Thought Leadership’ article at the link below