The threat from BBB-rated bonds is overrated
Much has been said about the fact that BBB-rated bonds now make up the majority of investment grade bonds in the US, UK and Europe. A lot of pessimistic market pundits fear that during the next recession, a lot of these BBB-rated issuers could get downgraded to junk and as a result suffer significant losses as many institutional investors are forced to sell these fallen angels. I have argued in a recent publication that the fears of such a rating meltdown is overrated because historical precedent shows that the impact on a diversified bond portfolio is likely to be limited and spread out over a long period of time.
Now, the good people at Columbia Threadneedle have looked under the hood of the rise in BBB-rated corporate bonds in the US and calmed me down even more. First, they point out that most of the increase in BBB-rated bonds has happened in the highest rating bucket of BBB+-rated bonds. That alone is of course not enough to soothe the nerves of any experienced investor who has been around a couple of corporate defaults in his or her lifetime. We all know that a BBB+-rated bond can be downgraded several notches at once and become sub-investment grade almost instantaneously in the case of a severe market downturn.
However, what I find interesting and important to remember is that 40% of the increase in BBB-rated bonds is due to the downgrades of banks like Citi or Barclays. That is simply a reflection of the lower credit rating banks have enjoyed since the end of the Global Financial Crisis (GFC). I think we all can agree that prior to the GFC many Western banks were probably rated too highly with credit ratings of A or better and almost none of them sporting a BBB-rating. Today, the capitalisation of these banks is much better than before the GFC, yet their credit rating is worse. So, at least this investor is not too worried about bank debt in the next few years. And even if we should encounter another financial crisis like 2008, we know that it is unlikely to create a massive default of a global bank like Citi. I know I am being cynical, but to me investing in bank debt is another case of “Masses of Idiots” moral hazard that I have described in the past. If you buy these bonds and they default, the potential consequences for the global economy would be so devastating that the government and central banks are forced to bail you out, whether they like it or not. But for those of you who do not want to engage in such cynical investment positions, the simple answer to limit downside risks of BBB-rated bonds is to avoid financials altogether.
Of course, besides the banks, nonfinancial institutions drove 60% of the increase in BBB-rated debt since 2010. As it turns out, this increase can almost completely be explained by four companies, the downgrade of AT&T in 2015 and Verizon in 2013 and the upgrade from junk bond status of GM in 2015 and Ford in 2012. Avoid these four issuers together with the banks and you will have a BBB-rated portfolio that looks very much like a BBB-rated nonfinancial portfolio in 2010. In short, containing the additional risks from the rise of BBB-rated bonds is relatively straight forward since it is due to a small number of issuers.
Growth in BBB-rated bonds 2010 to 2017
Source: Columbia Threadneedle, Bloomberg Barclays.