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How to pick junk-bond jewels despite oil's slide

It is possible to find jewels amid the junk. For investors who are nervous about oil-price declines and their effect on junk bonds issued by the energy industry, bonds that are on track for a credit-rating upgrade to investment-grade status still offer attractive returns. Although few of these top-rated bonds receive an upgrade in any given year, potential upgrade candidates as a whole remain an attractive bet.



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Investors will probably find fewer upgrade candidates among oil industry issuers. But outside of that, finding the right bonds is not simple. Over the past couple of years, the creditworthiness of companies has been improving, as a reviving global economy has resuscitated corporate profits. But in recent months, the pace of improvement has slowed.

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So far this year, S&P has only promoted five companies to its investment-grade category — about half the rate of 2013 and down from 24 upgrades in 2011. Even in the U.S., fewer companies are winning acceptance to the top tier of creditors, with 11 rising stars so far in 2014 against 43 in 2013, Bloomberg figures show. For context, Moody's rates 1,850 bonds Ba1 — its top category below investment grade.

But although it is hard to pick bonds that get an upgrade, issuers that are both top-rated and in the running for an upgrade are numerous.

For instance, a diversified globalized business empire — with interests in several industries across the world — will typically suffer less volatility in cash flow than smaller more focused rivals. This is something that credit rating agencies may reward.

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The stage of a company's evolution can also be important. Ambitious young companies frequently take on high levels of debt as they grow. As they mature, many develop a greater awareness of the merits of a strong balance sheet, and get rewarded with an upgrade. A change of leadership can have a similar effect.

Finally, investors should monitor the position of different industries in the business cycle. Some issuers that receive an upgrade belong to battered sectors — such as autos or construction — that are on the mend. Some industries — oil among them — may be less likely candidates.

This strategy also comes with a potential bonus attached. Our research shows that "rising stars" that receive an upgrade typically outperform by 2.5 percentage points surrounding the upgrade announcement.

The main reason for this outsized boost is technical. Many powerful institutional investors, such as banks and insurers, are banned from investing in sub-investment grade bonds or restricted in their holdings by regulation. As a result there is typically a wave of forced selling when a company is downgraded.

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"Rising stars" benefit from a reversal of this dynamic. Along with the institutions that now have the option of investing, there are also forced buyers — including funds that invest passively in investment grade bonds. This boosts returns beyond those achieved in the case of a "normal" credit upgrade.

Shifting through potential rising stars is a labor-intensive business. But for investors in general and especially those who are nervous about oil, it is a strategy that can be well worth the effort.

Commentary by Mark Haefele, global chief investment officer at UBS Wealth Management.