What Are Crossover Bonds and How Do They Work?
Understand crossover bonds, debt instruments bridging investment-grade and high-yield credit ratings. Learn their characteristics and market impact.
Bonds are financial instruments representing a form of debt, where an issuer, such as a corporation or government, borrows money from investors. In exchange for the loan, the issuer promises to pay regular interest payments over a specified period and return the original principal amount at maturity. A bond’s quality and likelihood of repayment are assessed by its credit rating. Credit ratings are evaluations provided by agencies that assess an issuer’s financial health and capacity to meet debt obligations, helping investors understand the risk. Within this framework, a unique category of debt instruments exists at the intersection of different risk profiles, known as crossover bonds.
Defining Crossover Bonds
Crossover bonds are debt instruments issued by companies whose credit quality places them on the border between “investment-grade” and “speculative-grade” categories. “Speculative-grade” is often referred to as “junk bonds” or “high-yield bonds.” This positioning means they possess characteristics of both higher-quality and riskier debt, stemming from their specific credit rating thresholds.
Major credit rating agencies, such as Standard & Poor’s (S&P), Moody’s, and Fitch, employ distinct scales. Investment-grade bonds are generally rated BBB- or higher by S&P and Fitch, and Baa3 or higher by Moody’s. Speculative-grade bonds begin at ratings of BB+ or lower from S&P and Fitch, and Ba1 or lower from Moody’s. Crossover bonds specifically fall within the lowest tier of investment grade (BBB-/Baa3) and the highest tier of speculative grade (BB+/Ba1). This narrow band defines their “crossover” status, signifying proximity to either side of the investment-grade threshold.
The “crossover” concept also implies a bond’s rating can change. A “rising star” bond was initially speculative-grade but improved its credit quality to investment-grade, typically due to improvements in the issuing company’s financial performance or stability. Conversely, a “fallen angel” bond was once investment-grade but downgraded to speculative-grade due to deteriorating financial condition. Such downgrades can result from declining revenues, increased debt levels, or industry-specific challenges.
Companies that issue crossover bonds often have distinct profiles. They include established companies facing temporary financial difficulties or restructuring, which may have led to a downgrade. Alternatively, they may be growing companies with improving but not yet fully established credit profiles nearing investment-grade status. This dynamic nature of their credit standing is a defining feature of the crossover bond segment.
Characteristics of Crossover Bonds
Crossover bonds exhibit a yield profile reflecting their intermediate risk position within the broader bond market. They offer higher yields than investment-grade bonds, compensating investors for greater credit risk. Their yields are lower than deeply speculative-grade bonds, indicating a lower risk of default than the riskiest high-yield segments. This provides enhanced income potential compared to traditional investment-grade offerings.
The implied risk of crossover bonds blends investment-grade and high-yield characteristics. They carry higher implied credit risk than pure investment-grade bonds due to the possibility of a downgrade. However, they have less risk than the broader high-yield market, often belonging to more established companies with a greater capacity to recover from financial setbacks. Historical data suggests that default rates for crossover bonds tend to be much closer to those of investment-grade bonds than to the overall high-yield market. For instance, BB-rated bonds, a significant portion of the crossover market, have historically shown average loss rates under 1% per annum.
Market liquidity for crossover bonds can vary but often sits between that of highly-rated investment-grade bonds and lower-rated high-yield bonds. Highly-rated investment-grade bonds are very liquid due to their broad appeal and frequent trading. While crossover bonds may not match this level of liquidity, they are often more liquid than some smaller, less-known issues in the deeper speculative-grade market. This enhanced liquidity relative to some high-yield segments is attributed to their larger market size and dual investor interest.
The diversity of issuers within the crossover bond segment is considerable, spanning various industries and company sizes. Industries such as telecommunications, automotive, energy, healthcare, consumer products, and financial services are commonly represented. This broad representation provides a wide range of investment opportunities within this unique credit spectrum.
Crossover Bonds in the Market
Crossover bonds occupy a unique position in the fixed-income market, appealing to a diverse investor base. Due to their dual nature, they fit within the mandates of both investment-grade and high-yield bond funds. Investment-grade funds may include them if guidelines allow for a slight deviation into higher-yielding, lower-rated securities. High-yield funds find them attractive as a higher-quality component within their portfolios, offering a better risk-adjusted return compared to deeper speculative-grade bonds.
The market perception and pricing of crossover bonds are sensitive to shifts in the economic outlook, interest rate changes, and specific news regarding the issuing company. An improving economic environment can lead to upgrades for “rising stars,” increasing their value. An economic downturn might result in more “fallen angels” and downward price pressure. Changes in interest rates also influence their pricing. Specific issuer news, such as changes in financial performance or corporate strategy, can significantly impact a crossover bond’s rating and market price.
Crossover bonds contribute to a diversified fixed-income portfolio by bridging the gap between two major bond categories. Their characteristics, which blend aspects of both investment-grade stability and high-yield potential, offer a distinct risk-return profile. This unique positioning can help balance overall portfolio risk while potentially enhancing returns compared to a purely investment-grade allocation. By incorporating bonds that sit at this credit quality intersection, investors can gain exposure to companies undergoing credit transitions, which may present specific opportunities.