Signal From Noise
Research
Signal From Noise
Research
Talk of a BBB Bond Market Implosion Overdone
– Worries about BBB debt abound but debt service ratios ‘well within norms’
– BBB space has exploded in size last 10 years to $3T
– BBB has returned 9% this year
I admit to being old enough to know there was a time when General Electric’s (GE) corporate bonds were highly rated instead of living at the bottom of the investment grade (IG) rating scale—among the BBBs—as is the case now. Equity investors might not be aware that the U.S. BBB corporate credit space has exploded in size in the past decade, up to roughly around $3 trillion in total, or about 50% of total investment grade. It dwarfs the $1.3 trillion high yield bond market, the next rung below it.
It’s easy to see why. Big banks scaled back lending for regulatory reasons since 2009. What corporate America did in response is straightforward: CEOs have taken advantage of the extraordinarily low interest rates of the past decade and loaded up on cheap debt to buy back stock; boost returns on equity; pay dividends and make investments. Additionally, investors have become more comfortable with IG’S lower rungs. One thing helped that. Yield. This year yield seeking investors and BBB investors have been rewarded, driving a nice rally in both BBB as well as high yield (HY) markets. For example, the Bloomberg Barclays US Aggregate index of IG bonds is up 9.4% year to date.
The downside is, however, a general deterioration in the IG world. In expanding economy, even a slow one, it isn’t a problem. On the other hand, in a recession, it could be. And there’s the rub. BBBs are getting increasing press and regulator attention, with the alarm bells going off. Given that BBB now dominates IG, the worry is that a bunch of BBBs could be downgraded to junk in the next recession, and the much smaller HY market will be force fed a lot of new paper, driving down prices. The BBB segment has grown significantly faster than the overall IG market. It was some 35% of IG in 2006 and 28% in 1997.
Many institutions holding BBB-, for example, aren’t allowed to hold junk, and in the event of a downgrade Armageddon there could be a lot of folks heading for exits simultaneously. That kind of panic could also spill over into the stock market. The Federal Reserve Board and the Bank for International Settlements have issued warnings about the high level of BBBs.
Should investors pay attention? Of course. Is it bad? Not particularly, until there is an economic contraction. As I’ve noted elsewhere, that doesn’t seem to be in the cards anytime soon. A more nuanced interpretation is required. Let’s look at the data.
As the nearby chart shows, BBB-rated debt, including all three rungs BBB+, BBB and BBB-, are now about 50% of the $6 trillion or so IG world. BBB-, the lowest, is about 25% of the BBB total.
But before you go out and shoot all your BBB debt, consider that there are strong arguments to hold your fire. In a report earlier this year, for example, Lord Abbett said there are potentially mitigating factors that can give rise to opportunities in the corporate debt space. The institutional investor also noted that the biggest share of BBB debt is issued by stable large caps, like AT&T (T) and Verizon (VZ), among others. Once a company becomes BBB- rated, it is less inclined to do things that threaten a downgrade because speculative grade markets aren’t as liquid or as cheap. Instead, companies on the cusp focus on ways to maintain or improve their balance sheet.
Debt Servicing Ratios Well Within Historical Norms; Non-Financial Corporate Leverage, Debt/EBITDA, 1985-2017*
Lord Abbett went on to say that although corporate leverage continues to increase as a percent of U.S. gross domestic product (GDP) and as a percent of book value, as the media has reported, operating margins have been robust as well, leading to debt servicing ratios that are well within historical norms. See the chart above. With debt at 3x EBITDA (earnings before interest, taxes, depreciation, and amortization) and interest rates so low, the debt levels “are very manageable, in our opinion…. We don’t see any evidence of the kind of speculative activity that historically precedes a recession.”
Another thing to consider are the issuers of the BBB market. Financials account for some $744 billion of the BBB, notes S&P Global Ratings, with nearly 80% of that rated BBB+ and much of it from large systemically important financial institutions (SIFIs), like Citigroup and Morgan Stanley. They are generally much better capitalized than they were before the Great Recession, with strong liquidity and funding profiles
Earlier this year, Tom Doubek, a Columbia Threadneedle Investments portfolio manager, wrote that over “90% of the growth in the BBB market has come from banking and a handful of issuers.” Much of the latter is telecom. “We don’t think the amount of BBB-rated debt is cause for immediate alarm.” Active management can help avoid the bad actors and focus on issuers with balance sheet strength to withstand a potential downturn.
Bottom Line: As long as the economy chugs along, even at slow speeds, don’t sweat the BBB market.
