Wednesday, October 16, 2019

Investment Insights

Are BBB-rated credit fears real or overblown?

By Wayne A. Anglace, Michael G. Wildstein & William E. Stitzer/Macquarie Group

The amount of debt in BBB-rated bonds – the lowest rung of investment grade categories – has risen substantially in recent years, now comprising 51% of the investment grade universe, up from 33% in 2010 (source: Bloomberg and Macquarie Investment Management). This development has captured investors’ attention, sparking fears that the growing number of BBB-rated companies, vulnerable to economic stress, could potentially lead to widespread downgrades to the high yield, or “junk,” bucket.

Despite these concerns, we favor being overweight in BBB-rated credit, believing that valuations in this ratings category are more attractive than higher-quality A-rated debt, perhaps due to these broad downgrade fears. The large and diverse BBB-rated part of the credit market we believe provides potential opportunities to invest in resilient credit stories that could reward investors through strong fundamental credit research and careful security selection, even during periods of economic stress.

We see several market factors that argue for remaining solidly invested in the BBB-rated credit portion of the investment grade market. These include the BBB category’s relatively wide disparities, such as differences in potential downgrade rates that can help serve as a rating “cushion.” Also, highly levered bonds with a mid-BBB or BBB- rating often have less room to avoid downgrades and we would suggest that these issuers have more incentive adhere to deleveraging plans and remain investment grade, whereas A-rated issuers may be more willing to take on leverage and sacrifice their ratings while still remaining investment grade. 

A rating “cushion” in BBB

The disparity of credit quality across the full BBB-rated market is notable. Approximately 75% of the BBB-rated market is either mid-BBB or BBB+, with only a small portion (25%) rated the riskier BBB-, the last rung on the investment grade ladder before falling to high yield (source: Bloomberg). We think it’s worth noting that three-quarters of the BBB market (BBB+ and BBB), which the press has written so much about recently, has one to two rating notches of cushion before being considered a “fallen angel” or dropping from investment grade. As the chart below shows, the mid-BBB and BBB+ categories combined have increased in recent years (as a percentage of the overall BBB ratings category), effectively expanding this relative ratings cushion to high yield, with the BBB- segment holding relatively steady and slightly shrinking since 2015 (sources: Bloomberg and Macquarie Investment Management).

The BBB market by ratings category

Click image to enlarge chart.

Higher ratings don’t necessarily mean safer

We see another important consideration at the lower end of the investment grade market, in that moving up in credit quality may not necessarily insulate investors from future losses due to ratings downgrades. Companies that are A-rated typically are larger and better capitalized than lower-rated peers – characteristics that could be seen as dry powder for shareholder-friendly activities, which could cause a ratings downgrade (while still maintaining a lower-investment-grade rating). Such events could lead to unexpected volatility in A-rated issues which often times are deemed “safer” by investors, simply due to a higher credit rating than that of a BBB-rated issue.

In a world of low interest rates (that is, low corporate borrowing costs), A-rated companies may be incentivized to reward shareholders and sacrifice their A-ratings. In some cases, this can make A-rated issuers that get downgraded to BBB a surprise to investors, in our view. In the graphic below, we show examples of A-rated companies that were downgraded, and the resulting effects before and after the downgrades. 

Effects of downgrading from A to BBB

Click image to enlarge chart.

Note: “A” index refers to the A-rated component of the Bloomberg Barclays US Corporate Investment Grade Index. Table shown is for illustrative purposes only. 

Looking past the headlines

As risk-aware investors in this shifting market environment, we believe it’s important to look past the headlines surrounding the BBB-rated market, and identify securities in this category that potentially offer more opportunity than even higher rated ones – but with research-based, careful credit selection as the key.

Investing involves risk, including the possible loss of principal. Past performance does not guarantee future results. Diversification may not protect against market risk.

Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.

Fixed income may also be subject to prepayment risk, the risk that the principal of a bond that is held by a portfolio will be prepaid prior to maturity, at the time when interest rates are lower than what the bond was paying. A portfolio may then have to reinvest that money at a lower interest rate.

High yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment grade bonds. Credit risk is the risk of loss of principal or loss of a financial reward stemming from a borrower's failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower expects to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation.

Bond credit ratings published by nationally recognized statistical rating organizations (NRSROs) Standard & Poor’s, Moody’s Investors Service, and Fitch, Inc. For securities rated by an NRSRO other than S&P, the rating is converted to the equivalent S&P credit rating. Bonds rated AAA are rated as having the highest quality and are generally considered to have the lowest degree of investment risk. Bonds rated AA are considered to be of high quality, but with a slightly higher degree of risk than bonds rated AAA. Bonds rated A are considered to have many favorable investment qualities, though they are somewhat more susceptible to adverse economic conditions. Bonds rated BBB are believed to be of medium-grade quality and generally riskier over the long term.

Note: All charts are for illustrative purposes only. Charts have been prepared by Macquarie unless otherwise noted. 
The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Macquarie or TEXPERS, and are subject to revision over time. 

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