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Don't be wary of a BBB-rating

Contrary to their reputation BBB-rated corporate debt has much to recommend itself.
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Corporate America has feasted on historically low interest rates over the last decade. A low after-tax, effective cost of debt set the table for companies to use debt for acquisition, share buyback and dividend increases. The result is the market value of the investment grade (IG) credit index (debt rated AAA to BBB-) has more than doubled over the last 10 years, reaching $6 trillion at June 30. Of this total, the BBB component has risen from nearly 31% to 44%. While these figures seem large and have caused a few to express concern, they pale in comparison to the market capitalization of the S&P 500 index, which hit $23 trillion at June 30—113% of U.S. GDP.

However, the 2017 tax law, which lowered the corporate tax rate and the rate on cash in overseas subsidiaries, has reduced the attractiveness of using debt and leverage. Companies still are issuing debt for share buybacks and M&A, but are directing more and more for capital expenditures. In fact, capex has risen over 8% in the last 12 months, making it the third increasing capex cycle since the 2008 recession. But some experts are saying that the 172% returns of IG bonds over the last 20 years, with BBB-rated returning 202%, are not just over, but headed for negative territory. While it is true that rising rates can take a bite out of a bond’s value, the Federal Reserve is indicating it expects inflation to be restrained in the short- to medium-term. That means the high return of BBB corporates might not plummet. But what about defaults, especially if a recession is nigh?

IG bonds bring credit risk if the companies have too much debt at the wrong part of an economic cycle. But at the moment, the U.S. economy looks strong, with few signs of impending recession. And in any case, the risk of default in the investment grade market has historically been extremely low: according to Moody’s, the average default rate for investment grade debt over the last 35 years is just 0.1%. And concern that IG bonds will suffer unduly in the eventual next recession seem overblown. Their worst year in the last decade—unsurprisingly 2008—was a loss of approximately 3%, compared to the S&P’s -37%. BBB-rated bonds fell 8.67%, but massively rallied in 2009 by 27.2%, even beating the S&P’s 26.4%.

Avoiding BBB debt now for fear of a bad outcome means passing up one of the largest sectors in the IG market whose risk premiums are positively correlated to the surging U.S. economy. However, this large and complex market may be best accessed through experienced portfolio managers and analysts. Unlike passive vehicles that typically try to replicate an index, active managers scrutinize companies, understand management objectives, choose whether to participate in specific new issuances, and trade bonds to take advantage of changes in company fortunes. Combining the wealth of information that Federated’s investment process generates with our fundamentally driven, bottom-up corporate bond analysis enables our team to produce not just good results, but also good risk-adjusted returns. Investing in BBB-rated corporates need not give one indigestion.

TAGS Fixed Income
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DISCLOSURES

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

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