Investment-Grade Corporate Bonds: Avoiding BBBs’ Sting
Strong market fundamentals are leading to an increase in lower-rated investment-grade debt that may struggle as rates rise.
Foreign buyers, predominantly out of Asia, have reduced the pace and size of U.S. corporate credit purchases. At the same time, Treasury yield curve flattening and rate volatility due to quantitative tightening have stymied the participation of domestic insurance companies, which otherwise would have made up for the shortfall in foreign demand. This is likely to exacerbate the existing steepening in the 10s/30s corporate credit curve, which was at year-to-date wides of 45 basis points at the end of the first half of 2018. Net issuance, down 25 percent year to date, has been a positive technical factor, but will reverse in the second half of 2018 as redemptions were front loaded in the first half of the year.
Spreads widening to levels not seen since December 2016, a backup in rates, and a steady flow of BBB mergers and acquisitions (M&A) financing contributed to investment-grade corporate bonds returning -2.75 percent through the first half of 2018, dramatically underperforming high-yield bonds and equities. Weaker demand from foreign buyers and increasing headwinds, mainly due to looming trade wars, will likely precipitate heightened volatility and limit spread performance in the third quarter.
BBB-rated bonds now account for around half of the investment-grade corporate bond universe, up from 30–35 percent 10 years ago. This trend has been driven by a slew of large M&A deals, such as the AT&T/Time Warner merger, which have successfully gained regulatory approval. Notwithstanding strong market fundamentals, the glut of BBB corporates is cause for concern as they are increasing leverage in a rising rate environment (see chart, bottom right). In the short term, we expect to see pockets of buying from domestic insurers and pension funds. With trade wars intensifying and an extended credit cycle, however, investment-grade corporate spreads remain vulnerable. To that end, we continue to prefer higher-quality corporates with lower spread beta. We believe this will work in our favor when lower-quality credits are exposed at the turn of the credit cycle and credit spreads widen. The rise of passive investors in the investment-grade space also exposes the market to forced selling in the event these bonds get downgraded to below investment grade, a problem that would only be exacerbated by poor liquidity conditions as investors head for the exit.
Rising Concentration of BBB Issuers Will Be a Risk When Credit Cycle Turns
BBB-rated bonds now account for around half of the investment-grade corporate bond universe, up from 30–35 percent 10 years ago. This negative rating migration introduces a greater risk of downgrades from investment grade into high yield when the credit cycle turns.
Source: Bloomberg Barclays, Guggenheim Investments. Data as of 4.30.2018.
Growing Ratio of Highly Leveraged IG and BBB Issuers vs. BB Market
The market value of investment-grade debt with leverage greater than the BB average (which currently stands at about 3.9x) is now greater than BB-rated debt outstanding in the Barclays High-Yield Index. At the turn of the credit cycle, potential downgrades into high yield could create liquidity disruptions as the high-yield market absorbs new entrants. This would affect investment-grade and high-yield investors alike.
Source: Bloomberg Barclays, Guggenheim Investments. Data as of 3.31.2018.
—Jeffrey Carefoot, CFA, Senior Managing Director; Justin Takata, Managing Director
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