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By  Farris G. Shuggi, CFA

Exploiting Durable Inefficiencies in High Yield Debt

Seeking to capture value from dislocation in high yield bonds.

June 2025, From the Field

Key Insights
  • Despite the broad characterization, not all high yield debt is created equal. 
  • Supply and demand imbalances in the high yield bond market contribute to a consistent opportunity to buy BB bonds at a discount. 
  • By understanding where investors are compensated for risk across and within asset classes, capital can be allocated in pursuit of superior risk-adjusted returns.
View Transcript

High yield bonds are thought by many to be a speculative, higher-risk asset. But within high yield, BB bonds have historically generated almost equity-like returns with lower volatility and better risk-adjusted returns. So how have these bonds, which are often characterized as “junk,” provided such great performance over time? 

BB bonds are the first credit tranche that is high yield debt.

When a bond is downgraded from a BBB credit rating, which is the last tranche of investment grade, to BB, it has often resulted in forced selling of that bond by investors who cannot hold non-investment-grade debt. These sellers have often included entities such as pension funds, insurance companies, and investment-grade institutional investors.

This forced selling has caused the price of BB bonds to decline and their option-adjusted spread to increase significantly. That increase in spread is the extra compensation above the risk-free rate that an investor expects to earn for the potential risk of default.

On average, a BB bond has earned about a 150- basis-point higher spread than a BBB bond, but the risk of default over a one-year period was only 0.5% higher, and the overall risk of default was just 0.7%. In other words, less than 1% of U.S. BB bonds have historically defaulted in any given year on average.

Thus, an investor could seek a significantly higher yield by taking on what has been only a very marginal increase in default risk. It is this asymmetry that has led to the great risk-adjusted returns for BB bonds.

     

Farris G. Shuggi, CFA Head, Quantitative Equity

Exploiting Durable Inefficiencies in GARP Stocks

By  Farris G. Shuggi

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