Recent months have seen growing warnings of a ‘bond catastrophe’ in the BBB space but the fixed income team at Royal London Asset Management isn’t too concerned by this risk – except for passive investors. 
The ultra-low interest rates and quantitative easing programmes that have been in place since the end of the financial crisis led to a dramatic rise in BBB issuance, or corporate bonds that are rated one notch above high yield – sometimes known as ‘junk’ status.
The size of the BBB sector of the sterling investment grade credit market has increased both in absolute terms, growing from £45bn at the end of 2008 to £221bn at the end of 2018, and as a proportion of the market, from 11 per cent to 39 per cent over the same period.
With the world’s central banks having to reverse their loose monetary conditions at some point, there are concerns that companies which have borrowed excessively will suffer ratings downgrades or default on their debt – leading to mark-to-market losses or even capital destruction for their investors.
Proportion of the sterling investment grade credit market in different ratings
Source: ICE
Man GLG Strategic Bond lead manager Craig Veysey recently said: “We are very, very cautious of those cyclical BBB- issuers that lack the flexibility to reduce the size of their balance sheet or increase their cash flow – we think a large number of these could quickly find themselves in the high yield index.”
Not everyone is as cautious about the BBB space, however. Ewan McAlpine, fixed income product specialist at Royal London Asset Management (RLAM), agreed that there are some reasons for concern about the BBB market and a prudent approach is recommended.
But he said the argument that there is a ‘bond catastrophe’ on the horizon for BBB-rated securities is “extreme and investors shouldn’t be spooked”.
“A key reason for our more positive outlook is our active investment approach. Through a strong investment philosophy and process, we aim to avoid bonds with an unfavourable risk/return trade-off and focus on assets with much more attractive risk/return profiles,” he said.
“We would be more concerned by the growth in BBB credit if we were passively invested across the whole rating band. Indeed, we would be concerned by passive investments across the entire ratings spectrum, as investing purely on the basis of index or rating ignores the potential benefits that non-benchmark or unrated bonds can offer.”
Events that took place in the autumn of 2018 appeared to some to offer a taster of the challenges that could hit the bond market if tightening monetary policy revealed the vulnerabilities of some indebted companies.
At the time, the Federal Reserve appeared to be committing to much faster interest rate rises in the US than the market had previously foreseen. McAlpine said the US bond market “cracked” because of this, with the benchmark 10-year US Treasury yield climbing from around 2.80 per cent to almost 3.25 per cent.
High corporate debt has created hundreds of ‘zombie companies’
Source: BofA Merrill Lynch Global Investment Strategy, Bloomberg
On 2 October, S&P downgraded GE and GE Capital bonds two notches from A to BBB+. “It seemed the doomsters were right,” the RLAM product specialist conceded, as GE – which had been the fourth-largest company in the world in 2012 – was shown to be a ‘zombie company’, or one that can only survive on cheap debt.
“This is what happens to over-extended companies when interest rates rise. It was surely just a matter of time until the BBB dominoes started to fall. So far, so depressing,” McAlpine said.
“However, we feel that while the factual basis for these fears isn’t wrong, the conclusions reached seem extreme and, while possible, investors shouldn’t be spooked by the dire predictions. Last year’s falls in government bonds and GE aren’t necessarily an augury of meltdowns in bond markets or a wave of corporate downgrades.”
He added that numerous analyses of the credit market have empirically shown that investment-grade credit and, BBB in particular, is no more risky today than in 2008.
In addition, RLAM said it sees “no evidence” to suggest that: ratings agencies have lowered their standards to allow issuers with questionable profiles cross over from high yield to BBB investment grade (“if anything, the opposite seems likely given the reputational damage suffered by ratings agencies in the aftermath of the financial crisis”); issuers on the whole are more leveraged or less able to service their debt; or BBB issuers are more likely to be downgraded or default than in previous market cycles.
Indeed, the fixed income team at RLAM continues to see opportunities in the BBB space. The firm’s bottom-up approach largely ignores ratings, seeing them as “a source of inefficiency”. “Rather we always look at the particular bond to assess whether we are being adequately compensated for the risk taken – and have found that many of these bonds have been rated BBB,” the commentator explained.
McAlpine said sterling investment-grade credit investors need a yield premium to gilts of around 40 basis points to compensate for the risk of default.
Credit spreads in this part of the market stood at around 130 basis points at the end of March 2019, meaning investors were receiving a “generous” 90 basis points for other risks such as lower liquidity or ratings migration. What’s more, BBB investors are being better compensated for the additional risk of default with a BBB credit spread of around 200 basis points.
“Over recent years, BBB-rated bonds have consistently outperformed, with lower volatility of returns, compared to the broader market. In particular, returns have been better and smoother than those of A-rated bonds,” the fixed income product specialist said.
“The reasons for the increase in their share of the market size are partly performance-related, but also due to migration from higher ratings to lower ratings as well as strong issuance of BBB-rated bonds in the sterling market.”
Risk/reward of sterling bonds over 10yrs to end of 2018
Source: ICE
Of course, RLAM noted that there are risks to BBB bonds. One is the possibility that the US economy could go into recession in 2020, which could affect credit markets and result in some downgrades and defaults.
However, while BBB issuers will not be immune to this, the firm thinks it unlikely that downgrades from BBB overwhelm the high yield market as it believes there is plenty of leeway and cashflow in stable sectors to absorb downgrades, especially in the US.
“Despite the possible negative economic scenarios, we believe BBB-rated credit bonds continue to offer attractive risk-adjusted returns; even factoring in the higher default rates expected for lower-rated bonds, they should still deliver more attractive returns than other sectors,” McAlpine concluded.
“Although rising interest rates could pose some challenges, we believe BBB credit can continue to outperform. Switching to higher-rated credit or even government bonds is likely to have a negative impact on long-term investment returns.”