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Investment Grade Corporate Bond Risk

Now is the time for quality investments, especially in fixed income.

bantam inc jack duval multi-family office ultra high net worth manhattan - bond volatility chart

There's a storm coming, Mr. Wayne. (MOVE US Treasury volatility index is set to rise from decade lows.)

Many investors are unaware that 49 percent of all outstanding investment grade corporate bonds are BBB rated (one notch above junk status), up from 34 percent 10 years ago.  This is a 44 percent increase in a decade, something unprecedented.

Chart 1: BBB Bonds as Percent of Investment Grade Index[1]

bantam inc jack duval multi-family office ultra high net worth manhattan - chart of BBB percentage of investment grade bond index

In fact, the entire corporate bond market (not just investment grade) has become something of a toxic wasteland of junk bonds, leveraged loans (for those firms not strong enough to issue any more junk bonds), and BBB (on-the-cusp-of-junk) rated bonds.

Chart 2:  The Corporate Bond Market[2]

bantam inc jack duval multi-family office ultra high net worth - chart of corporate bond market components

This shifting of corporate debt to lower quality comes at the same time as an explosion in the amount of total debt outstanding since the Global Financial Crisis (and even the end of the Clinton administration).

Chart 3: U.S. Bonds Outstanding  [3]

bantam inc. jack duval multi-family office ultra high net worth manhattan - sifma chart of total bonds outstanding

The reason for the debt explosion and shift to lower credit quality is due to two factors: corporations having low organic growth and the Federal Reserve lowering short-term interest rates to below one percent and keeping them there from the Global Financial Crisis (“GFC”) to 2017.

Over this time, the managements of many large corporations surveyed the field and, finding organic growth hard to generate, decided to use debt to buy other firms or (trigger warning) their own stock.  They pushed the debt issuance to the point where their debt was rated at the lowest end of the investment grade spectrum.

Investmenet Grade Bond Risk, Meet Yogi Berra

Over this time, many acquisitions were done at five times EBITDA, which is 40 to 50 percent higher than the norm before the GFC.  In theory, these firms will be selling off non-core assets to help pay down the debt and get those EBITDA multiples back to historical levels.  But, as Yogi Berra taught us: “In theory, there is no difference between theory and practice.  In practice, there is.”[4]

Generally speaking, this has not happened yet.  Also, with the recent market selloff and the economy flashing warning signs, it appears these sales will be made into a weak market and not at optimistic prices.  This means less debt will be paid down, and coupled with higher interest rates on the remaining debt, will result in widespread downgrades.

As with the sub-prime mortgage crisis, the ratings agencies are culpable and have tacitly agreed to not rate these bond issues below investment grade.  (Remember, the bond issuer pays for the ratings underwriting.). This has lasted for many years, but even the highly conflicted ratings agencies will ultimately have to bite the hands that feed them.

The Problem

Interest rates have been rising and the economy looks primed for a recession.  (For instance, many classic late-cycle indicators are flashing red, such as serious weakness is chemicals, housing, and car sales.). Given that we are 10 years into the longest continuous economic expansion in the history of our country (or any other country for that matter), a recession could be sharp and painful.  Ten years of mal-investment and excessive risk taking will not be unwound with a mere 10 percent “correction”.

Whenever a recession does hit, earnings will decline across the board for all companies and the debt service ratios will spike, leading to downgrades.  Since almost half of that debt is sitting on the edge of junk status, much of it will be downgraded into junk bond territory.

The BBB to BB Downgrade

The downgrading of an investment grade bond into non-investment grade (junk) status is a special event because many mutual funds, pensions, and other asset managers are prohibited from owning non-investment grade bonds.

This means those bonds will have to be sold, often times immediately.

The forced sales of newly non-investment grade bonds will cause their prices to fall more than a similar sized downgrade that was still within the investment grade spectrum.  For example a AA to A move.

This, in turn, will cause investment grade corporate bond funds to decline, possibly quite a lot.  For example, if all the BBB paper were to decline by 10 percent , it would shave five percent off the investment grade index.

While these declines will not be as severe as those of stocks, it will be most unwanted for investors, because they will fail to provide ballast for declining equity prices.  For the past 40 years, when the stock market has declined, the bond market has rallied and helped to cushion the fall, at least for investors who were diversified.

This will not happen with corporate bonds in the coming cycle.  (It will, however, still hold true for US Treasury bonds, other government obligations, and likely the highest quality corporate and municipal bonds.)

The problem is that many investors have been pushed out on the fixed income risk spectrum in their search for yield.  In past cycles, investors had most of their fixed income allocations invested in high quality issuers, with only small allocations to junk bonds.

This is no longer the case.  The Federal Reserve’s near zero interest rate policy has starved investors of yield, and forced them into risky assets.  Many have chosen to increase equity allocations and/or to highly overweight junk or low-quality bonds.

The increase in risk from yield-chasing will not end well.

Hidden Investment Grade Bond Risk Example

The biggest impact will likely be seen for investors who think they are well diversified, but have low-quality fixed income exposures.

For example, a client with a 50/50 (stocks/bonds) mix could see their losses double from historic norms.

Historically, investors could assume a typical stock market decline of 30 percent would be offset by a 10 percent rise in high quality fixed income investments.  In such a scenario, a 50/50 portfolio would have a net decline of 10 percent:  negative 15 percent from the stocks and plus five percent from the bonds.

However, if that same investor were invested with the same 50/50 allocation, but with the fixed income in low-qualify issues, their decline could easily be 20 percent: negative 15 percent from the stocks and negative five percent from the bonds.

In short, many investors will find their entire portfolio has become correlated and both their stocks and bonds declining at the same time.

Investor Understanding of Investment Grade Bond Risks

In my experience, most investors assume their fixed income investments are conservative and safe.  When they get their statement and see a pie chart on the first page showing half their investments in the fixed income slice, they assume that money is safe.

If those assets prove to be equity-like (or even partially so), they will be facing significant, and unexpected losses.  Furthermore, they will be unable to rebalance by selling bonds when they are high and buying stocks when they are cheap, one of the most reliable and easiest trades of the past 40 years.

Now is the time for quality investments, especially in fixed income.

________

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Notes:

[1]        Tortoise; “The Storm Surrounding BBB-Rated Corporate Credit”; September 2018.  Available at: https://tortoiseadvisors.com/mc/attachments/512/Market%20Insight_The%20Storm%20Surrounding%20BBB%20Rated%20Corp%20Credit.pdf; Accessed November 27, 2018.

[2]       Danielle DiMartino Booth; “The Corporate Bond Market is Getting Junkier”; Bloomberg; July 10, 2018.  Available at: https://www.bloomberg.com/opinion/articles/2018-07-10/corporate-bonds-are-getting-junkier;  Accessed November 27, 2018.

[3]        U.S. Bond Market Issuance and Outstanding; SIFMA. Available at: https://www.sifma.org/resources/research/us-bond-market-issuance-and-outstanding/; Accessed December 11, 2018.

[4]        This quote is often attributed to Yogi Berra, but appears to have originated with Walter J. Savich in his book Pascal: An introduction to the Art and Science of Programming.  See https://en.wikiquote.org/wiki/Yogi_Berra; Accessed December 10, 2018.

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