INVESTING

Making the grade: How risky are BBB bonds?

Oct 7, 2019

Economic uncertainty has increased investor focus on the possibility of BBB-rated bonds being downgraded to junk. Investors should weigh this risk with their search for yield.

Over the past several months, I have been fielding more questions about the state of the BBB-rated bond market. (BBB is the lowest tier of investment grade.)  As this credit cycle has lengthened, investors are concerned about the potential for a large amount of bonds being downgraded to junk, a status known as “fallen angels.” In this post, I’ll assess the risks of this growing market and how they can position for a potential downturn.

Growth of the BBB bond market

Over the past decade, the investment-grade corporate bond market has grown as issuers have taken advantage of rock-bottom interest rates and increased demand from yield-starved investors. Today, the BBB-rated segment now makes up over 50% of the investment grade market versus only 17% in 2001. Over the past decade, U.S.-related BBB corporate debt has grown 2.2x to $2.5 trillion, representing $1.2 trillion of net new issuance and $745 billion of downgrades from a higher credit quality.2

Credit spreads, or the additional yield investors receive above Treasury bonds, have not widened, even as more debt has been issued. (Widening spreads point to increased risk expectations.) This is due to a number of global factors. In the U.S., after years of near-zero interest rates, investors are searching for yield, making them look at lower-quality investment grade securities like BBB bonds. At the same time, foreign investors have been drawn to U.S. corporate bonds, which continue to see solidly positive yields, as other developed markets are seeing negative bond yields. 

BBB downgrade risk: Is a wave of fallen angels on the horizon?

Given that rating downgrades tend to coincide with recessions, a more recent concern among investors has been whether the BBB sector is poised for significant downgrades into high yield territory. While central bank stimulus is stretching the credit cycle by spurring economic growth, highly levered or cyclical credits could be at risk.

Read more about bond ETFs from Karen.

However, some issuers will be able to defend their credit ratings. First off, many BBB companies have tools at their disposal to keep their investment grade standing. For example, they can cut or eliminate stock dividends, share repurchase programs, or M&A activities. Kraft Heinz Foods suspended its dividend in February 2019 after poor earnings to ensure timely payment of their BBB-rated bonds.3 Additionally, many companies issued longer-dated bonds—locking in low borrowing costs and reducing refinancing risk going forward.

How a bond ETF deals with downgrades

Most investment grade bond ETFs seek to track an index from providers such as Bloomberg Barclays, ICE or Markit iBoxx. These providers determine a bond’s rating by using a blend of ratings from Moody’s, S&P and Fitch. Typically, if a bond gets downgraded by multiple rating agencies to BB+/Ba1 or below, then it will be considered high yield or junk, and the index will remove it at the end of that month. The ETF’s portfolio manager will also seek to remove the bond from the portfolio and obtain best execution for the fund. The portfolio manager can choose when to trade the bond and they are not forced to trade on month end. But they will remove the bond so over time an investment grade fund will remain that way.

ETF implementation ideas

Investment decisions around the risk of BBB downgrade, then, will depend on your view on the likelihood of the U.S. entering a recession versus the need for yield in your portfolio. Below are three bond ETF strategies to consider:

  • Avoid BBB-rated corporate bonds with iShares Aaa – A Rated Corporate Bond ETF (QLTA). QLTA holds only AAA-A corporate bonds.
  • Seek higher-quality investment-grade bonds with iShares Edge Investment Grade Enhanced Bond ETF (IGEB). IGEB is a corporate bond fund that uses fixed income factor insights to screen out lower-quality and overvalued bonds, potentially mitigating BBB downgrade risk.
  • Seek growth opportunity from a potential fallen angels premium with iShares Fallen Angels USD Bond ETF (FALN). Bonds tend to experience significant price declines when they are first downgraded, yet over time fallen angel issuers have tended to outperform the broad high-yield market as they rebound from being oversold and undervalued.

1 Source: Board of Governors of the Federal Reserve System, as of 3/31/2019.

2 Source: Morgan Stanley, Corporate Credit Research, as of 10/5/2018.

3 Source: NASDAQ, Kraft Heinz Company Common Stock Dividend History.

 

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities. An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency and its return and yield will fluctuate with market conditions.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets or in concentrations of single countries.

There can be no assurance that performance will be enhanced or risk will be reduced for funds that seek to provide exposure to certain quantitative investment characteristics (“factors”). Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods. In such circumstances, a fund may seek to maintain exposure to the targeted investment factors and not adjust to target different factors, which could result in losses.

Buying and selling shares of ETFs will result in brokerage commissions. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this material is at the sole discretion of the viewer.

The iShares Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).

The iShares Funds are not sponsored, endorsed, issued, sold or promoted by Markit Indices Limited, nor does this company make any representation regarding the advisability of investing in the Funds. BlackRock is not affiliated with Markit Indices Limited.

©2019 BlackRock. iSHARES and BLACKROCK are registered trademarks of BlackRock. All other marks are the property of their respective owners.

ICRMH1019U-965343-1/1

  • The Queen’s Gambit Declined
    Investing

    The Queen’s Gambit Declined

    Feb 25, 2021 | By BlackRock
    Rick Rieder and team contend that a chess strategy can offer insight into why holding some cash may be the right defense for portfolios today.
  • As volatility fades, can cyclicals shine?
    Investing

    As volatility fades, can cyclicals shine?

    Feb 17, 2021 | By Russ Koesterich, CFA, JD
    BlackRock Global Allocation Fund portfolio manager Russ Koesterich explains why he expects volatility to drop -- and cyclicals outperform.
  • What’s the Value of a Dollar?
    Investing

    What’s the Value of a Dollar?

    Feb 9, 2021 | By Rick Rieder
    Rick Rieder and team think that today’s potent policy cocktail holds key implications for economic growth, markets and the value of a dollar.
RSS

Get the latest updates from our RSS feed

Subscribe to our weekly insights email

Please try again
First Name *
Please enter a valid first name
Last Name *
Please enter a valid last name
Email id *
Please enter a valid email
Country *
This field is mandatory
 Thank you
Thank you for subscribing to BlackRock Market Insights