High yield bond investors face call conundrum, says Morgan Stanley

In a recent research report (Leveraged Finance Insights, 1 April), Morgan Stanley points out that with nearly two-thirds of the US high yield market now consisting of callable bonds, investor are often facing highly negatively convex exposures. In other words, bonds are unlikely to trade up much from their current average of 104 (based on cash index levels), since calls put a cap on the price. But if the economy falters and defaults pick up, the downside could be large.

Call options are not so much of a problem for triple C issuers, where bonds typically still trade at a discount to par, even though 76% of triple C bonds are callable, according to the report. Nor is it a problem with fallen angel issuers, since these bonds are not usually callable: as a result, only 44% of double Bs are callable. But for single B bonds, where 82% of securities are callable and where the bonds typically trade right on top of the call price, it poses a big headache for investors. Morgan Stanley suggests owning a barbelled portfolio of triple Cs and double Bs, rather than one made up of manly single Bs, to alleviate the problem.