Over the past four years, there has been a substantial rise in the volume of US bonds sitting at BBB-, just one notch above junk status. This could create vulnerabilities in the corporate credit market when the cycle eventually turns.
According to JP Morgan’s fixed income research piece, “How Big is the BBB- risk?”1, the amount of BBB- rated, non-financial sector bonds has grown by more than 70% over the past four years, from US$240 billion to US$575 billion. This represents 16% of the US dollar, investment-grade bond market. While still investment grade, the growth rate for the BBB- bond market is 1.5 times that of the total investment grade non-financial market.
Across the board, the whole cohort of BBB bonds has increased by 155% since March 2009. It now comprises 50% of the US investment grade market’s total nominal debt. In 2009 this figure was just 35%. This compares to the AA and A markets, which have respectively increased by 68% and shrunk by 78%. This suggests an increasing divergence between higher and lower quality credits.
Over the same period, US corporate and public sectors have increased their indebtedness, while US households have reduced their debt levels. In this environment, downgrades and a growing number of ‘fallen angels’ are risks for the building BBB cohort. Fallen angels are bonds whose credit ratings fall into the high-yield category, for example due to higher debt burdens when the economy eventually slows, most likely due to tighter monetary policy.
There are a number of drivers behind the growth of the BBB segment. These include rising M&A activity funded by new issuance, the increase in rating migration on the back of the 2015/2016 commodity correction, higher sub-debt issuance and generally lower bank ratings on the back of regulatory reform.
The segmentation of the investment grade and high yield markets in the US is also exacerbating potential liquidity risks. The BBB- rated cohort has a much higher probability of default and has greater downward rating migration risk. According to a report from JP Morgan2, 25% of bonds rated BBB- on 1 January in any given year are not rated in the BBB- category by year end.
Investment-grade deal sizes and the time to maturity for BBB- bonds are significantly larger than for the average high-yield bond deal. So, this could potentially make it more difficult for the high-yield market to absorb any significant increase in the volume of fallen angels. The average duration in investment grade debt is seven years, compared to four years for high-yield bonds. Any surge of bonds falling to high yield could occur right when the high-yield sector could experience cash outflows.
Other forces are also at play. Passive and ETF strategies are increasing their allocation to the asset class. Additionally, the structure of the liquidity backdrop has changed as market makers have withdrawn from credit markets on the back of regulatory reform. The upshot is spread volatility could be significantly amplified and investors could face the risk of higher capital losses.
Despite these looming risks, we still think with careful security selection there is value in global credit markets and we remain overweight as we think carry is still compensating for these risks, despite valuations not being as attractive. However, we prefer to move up in credit quality, maintain shorter credit spread duration in our portfolios and use risk management strategies to minimise any capital volatility.
1 JP Morgan “How Big is the BBB- risk?” 2018
2 JP Morgan “How Big is the BBB- risk?” 2018
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