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BBB-rated bond issuers - those just one notch above high-yield - now make up half the investment grade universe. That could have serious consequences in a downturn.
Written by
Shaniel Ramjee, Senior Investment Manager
Supriya Menon, Senior Multi Asset Strategist
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History doesn’t always repeat itself. A profound shift in the US corporate bond market will likely make the next crisis – whenever it comes – look quite different to previous ones. Compared to previous cycles, the proportion of bonds with the lowest possible investment grade rating (IG) – BBB – is exceptionally high, having increased sharply over the past decade. BBB-rated debt now accounts for around half of the whole market in both Europe and the US (see chart).
rise off bbb
Share of BBB-rated debt in US IG universe, %
Source: ICE BofAML US Corporates Index (IG), Datastream. Data covering 19.09.2008-21.09.2018
One reason for the increase is that more firms have been turning to the credit market for funding as banks have scaled back lending in response to tougher regulations. At the same time, companies have been borrowing heavily to fund acquisitions – indeed firms operating in the telecom and consumer sectors, which have been particularly active in M&A, make up a substantial proportion of BBB-rated bonds – each sector accounts for around 8 per cent of the universe. Meanwhile, there has also been an increase in debt-funded buybacks and dividend payouts.
Consequently, today’s investment-grade bond market is, in aggregate, significantly more risky than in the past.
This is a problem because in periods when economies slow, or default rates rise, a significant proportion of BBB-rated borrowers tend to be downgraded as their finances deteriorate. This pushes them out of the investment-grade universe and down in to the high yield market. Sectors that are more defensive and have struggled to keep up with the broader pace of earnings growth would tend to be hit hardest. Portfolios which mostly or exclusively focus on investment-grade debt would therefore be forced to sell.
That would clearly have serious repercussions for the market as a whole. But, arguably, the impact on the high-yield segment would be even greater as that market is forced to absorb a large volume of newly-downgraded paper. During previous credit downturns, around 5-10 per cent of BBB-rated US debt was downgraded, worth around USD60-80billion on average. Based on today’s USD3.1 trillion BBB-rated market, any equivalent downturn would create at least USD 150 billion of these fallen angels. That would be a huge amount for a USD1.3 trillion high yield universe to soak up.
dominant market
ICE BofAML US credit market indices, full market value, in USD million
Source: Datasteam. Data covering 19.09.2008 – 21.09.2018.
The only way for this mass of fallen angels to be absorbed by the market at a time when liquidity conditions are likely to be strained is through price. This will also affect new issuance, as costs for borrowers rise.
Consequently, we think both investment grade and high-yield bonds are riskier than their yields currently suggest. While we do not anticipate an imminent end to the credit cycle, as it grows ever longer in the tooth ever more stresses will appear. We think the predominance of BBB-rated paper make investment-grade bonds among the least attractive parts of the debt market.
Andrea Delitala, Head of Multi Asset EuroOctober 2018
About
Shaniel Ramjee
About
Shaniel Ramjee
Shaniel joined Pictet Asset Management in 2014 as a Senior Investment Manager in the Multi Asset London team.
Previously Shaniel worked at Barings Asset Management as an investment manager in the Global Multi Asset Group for 7 years.
Shaniel holds a MSc in Finance from the University of St. Andrews and a BA Hons in Economics and International Business from the University of North Carolina at Chapel Hill (US). Shaniel is a Chartered Financial Analyst (CFA) charterholder and holds the Investment Management Certificate (IMC).
In 2016, Shaniel was one of Financial News’ 40 under 40 Rising Stars in Asset Management.
About
Supriya Menon
About
Supriya Menon
Supriya plays a vital role in providing the Multi Asset team in London with in-depth investment research that helps steer tactical and strategic asset allocation decisions. She has built out cross-asset decision-making quantitative indicators covering valuation, fund flows and macro areas that are used across the firm. Supriya provides the Pictet Asset Management Strategic Unit with monthly Sentiment and Technical analysis and contributes to long-term thought leadership pieces.
Having joined Pictet Asset Management as a strategist in 2012, Supriya moved to the Multi Asset London team in 2018, where she assists the portfolio managers in decision-making and generates trade ideas for the balanced and multi-asset products. Supriya also communicates the team’s investment strategy to institutional clients and regularly appears on international media channels.
Supriya started her career at Morgan Stanley in 1999. She then worked as an Equity Strategist and Investment Analyst at Lehman Brothers from 2005 to 2009 after which she joined Aviva Investors as a Macro Strategist.
Supriya holds a BA in Economics and International Relations from Mount Holyoke College, Massachussets, USA and an MBA from the Harvard Business School.
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