Should you be wary of a BBB rating?

11-01-2018

Historically low interest rates spawned a corporate debt explosion over the last decade, with companies issuing bonds and other forms of debt to finance acquisitions, share buybacks and dividend increases. The result saw the market value of the investment-grade (IG) bonds (debt rated AAA to BBB-) more than double over the last 10 years, reaching $6 trillion as of June 30. Of this total, the lower quality BBB segment jumped from nearly 31% to 44% of the IG market as measured the Bloomberg Barclays U.S. Credit Index (BBUSCI). While this growth has raised some eyebrows, it should be kept in perspective: the market value of BBB bonds still pales in comparison to the market capitalization of the S&P 500 Index, which stood at $23 trillion as of June, equivalent to 113% of U.S. GDP.

The after-tax appeal of using debt and leverage has declined as interest rates have risen. Also contributing to the decrease is tax reform, which lowered the corporate tax rate and the rate on cash in overseas subsidiaries. That said, companies continue to issue debt for share buybacks, mergers & acquisitions and, increasingly, for capital expenditures (capex). In fact, capex has risen more than 8% over the past year. Still, some worry that the current environment may bring to an end a prolonged bullish period for corporate bonds. Cumulative IG returns totaled 172% over the last 20 years, with the BBB component returning an even larger 202% in the same period, as measured by the BBUSCI.

While it is true rising rates can take a bite out of a bond’s value, the Federal Reserve has indicated it expects inflation to be restrained in the short to medium term, suggesting BBB corporate returns should remain competitive, particularly if the economy continues to chug along, as we think it will. But even if the economy unexpectedly slows down dramatically—or at worst, enters recession—history suggests IG bonds tend to have limited defaults and only modestly negative down periods. According to Moody’s, the average default rate for IG debt over the last 35 years is just 0.1%. And the worst year for returns on IG bonds in the last decade—unsurprisingly 2008—was -3%, with the BBB-rated component off -8.7% that year. By comparison, the S&P return plunged 37%. And when the markets rebounded the following year, BBB bonds even outperformed the S&P, returning 27.2% versus the S&P’s 26.4%.

Put another way, avoiding BBB debt now for fear of a bad outcome means passing on one of the largest sectors in the IG market. However, it may be best to access this large and complex market during the present challenging period through active strategies that rely on experienced portfolio managers and analysts. Unlike passive vehicles that typically are constrained to just trying to replicate an index, an active approach that scrutinizes companies and their managements has the flexibility to choose whether to participate in new issuances and make trades to take advantage of changing circumstances. It is a fundamentally driven, bottom-up process that, from our vantage point at Federated, lessens reasons to be wary of BBB corporates, whether in the current environment or over the long term.

John Gentry
John Gentry, CFA
Senior Portfolio Manager, Head of Corporate Fixed Income Group