Investment actions

Assessing risks in the BBB-rated corporate bond market

As the global economy shows signs of late-cycle behavior, we believe it is important to assess the risks that exist in the BBB-rated corporate bond market and explore potential solutions for minimizing exposure to rating downgrades.

 


Capital at risk. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed.

The growth of BBB-rated corporate debt

The investment-grade corporate debt market has grown rapidly in recent years. Global capitalization reached over $10 trillion in 2019 from just over $2 trillion at the start of 2001. In the U.S., corporate debt as a percentage of GDP now stands at 47%, its highest level since 2009.1

At the same time, the lowest rated part of the investment-grade market has grown particularly quickly. Globally, BBB debt makes up over 50% of the market versus only 17% in 2001.

BBB-rated bonds represent over 50% of investment grade debt
BBB share of global investment grade corporate market

BBB bond share of global investment grade corporate bond market

Source: Bloomberg Barclays, as 6/28/2019.

Drivers of growth in corporate bond markets

The decade-long period of ultra-low interest rates has been the main backdrop for this period of growth. Historically low global interest rates are encouraging companies to use more debt to fund business operations, refinance existing obligations, conduct M&A activity, and/or expand dividend or share buyback programs. This burgeoning global supply of corporate debt has been met by strong demand by yield-starved investors.

Credit fundamentals and downgrade risks

While the popularity of investment-grade debt has been surging, the fundamental creditworthiness of the bonds has weakened by historical standards. Investment-grade corporate leverage levels have been on the rise since 2011 and are now approaching the highest readings since 1992.

Investment-grade leverage levels are higher than historical norms
Leverage of global investment grade corporate bonds

Leverage of global investment grade corporate bonds

Source: Morgan Stanley, Bloomberg, as at 3/31/2019. Gross leverage is calculated as total debt / 12-month EBITDA. Net leverage is calculated as (total debt less cash and cash equivalents) / 12-month EBITDA. A shrinking basis between Gross – Net Leverage is usually a sign that investment-grade balance sheets are holding less cash. Higher measures of leverage typically indicate greater issuer risk.

Look out for “fallen angels”

We believe the sharp increase in the proportion of BBB-rated constituents has made the investment-grade bond sector riskier than in recent years. BBB-rated bonds are typically the most vulnerable of all investment-grade debt in a recession. Any downgrade of such bonds would relegate them from the investment-grade universe to the high yield universe (making them “fallen angels”), which would negatively re-rate their value.

Analysis by Morgan Stanley has found that significant volumes of BBB-rated bonds were downgraded in previous credit downturns. In the 2007-09, 2000-03 and 1989-91 downturns, between 23% and 45% of investment-grade bonds were downgraded to junk. If downgrade rates were to remain at such levels, the next downturn could see approximately $600 billion of BBB bonds consigned to junk status.2

Companies may be able to protect their ratings

Inevitably, some of the most highly levered BBB-rated credits will likely be downgraded to high yield. However, many companies have tools at their disposal to help protect their credit rating.

Given many of these companies rely on access to investment grade capital markets to fund business operations, a significant portion of the BBB-universe is highly motivated to remain investment grade. If faced with being downgraded, companies can cut or eliminate stock dividends, share repurchase programs and M&A activities.

Nevertheless, we believe investors should remain diligent as a slowdown in the global outlook or recession could limit companies’ ability to protect their ratings—potentially increasing the risk of more downgrades.

Quantifying BBB downgrade risk

One way to quantify the risk of downgrades is to examine the price impact of “fallen angel risk”, or the risk posed by investment grade bonds that are downgraded to high yield.

Looking back over the past 20 years, we found that fallen angel bonds declined sharply in the three months prior to being downgraded, creating a drag on the returns of the overall market of U.S. investment grade corporate bonds. In some years, fallen angel bonds detracted only 0.05%, while in 2016 they detracted over 2.5%.

Fallen Angel risk can meaningfully detract from returns
Return contribution and market share of bonds downgraded to high yield

Fallen angel bond impact on returns

The figures shown relate to past performance.  Past performance is not a reliable indicator of current or future results. Source: Bloomberg, BlackRock, as of 6/30/2019. The left axis represents excess return contribution measured from every name that fell out of the Bloomberg Barclays US Credit Index 3 months prior to its rating downgrade. The right axis represents % market value of the downgraded names that fell out of the Bloomberg Barclays US Credit Index.

The potential impact of downgrades varies and the magnitude can be influenced by the stage of the credit cycle. In early- and mid-cycle environments, performance drag due to fallen angels tends to be benign, as risk assets generally perform well, and defaults/downgrades are low.  However, in late-cycle environments, such as the early and late 2000s, high-yield default rates tend to increase, the percentage of fallen angels can rise, and the impact on performance can become more pronounced.

Cumulatively, the performance drag due to fallen angel bonds can be significant for investment grade credit portfolios.

Navigate BBB bonds by screening out the riskiest credits

We believe investors looking to manage downside risks posed by issuer downgrades can benefit from a credit-screened approach to corporate credit investing. These types of strategies seek to invest in a broad portfolio of bonds that closely resemble a capitalization-weighted index, while removing issuers at greatest risk of downgrades, which could lead to sharp price declines.

Screening seeks downside management by avoiding deteriorating credits
Credit screening investment process

Credit screening investment process

Source: BlackRock Systematic Fixed Income, as of 6/30/2019. Investment process is subject to change. *Proportion of screened out issuers can vary over time, rising in times of perceived high risk.  ** Optimization process based on stratified sampling approach aims to maintain portfolio yield comparable to benchmark, while being more defensively positioned towards credits deemed to be high risk.

As systematic fixed income investors, we believe credit-screened strategies can offer the potential for yield opportunities that investors need from investment grade credit but with downside management in the face of volatile markets.

Key takeaways

  • The weaker fundamentals of the BBB-rated portion of the corporate bond market may make investment grade bonds riskier than in years past.
  • Credit downgrades to below investment grade status can meaningfully detract from investment returns.
  • Credit-screened strategies may help to reduce the risk of credit downgrades by avoiding the riskiest investment grade bonds.