The credit market is not broken The credit market is not broken

The credit market is not broken

The majority of BBB-rated debt is issued deliberately by healthy companies, not those on the brink.
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The latest popular media narrative is equating lower-rated investment grade corporate debt to a powder keg, with the only question being when the fuse will be lit. We think reality is another story altogether.

Spurred by global monetary policy, the extremely low interest rates of the past 10 years enticed companies to issue bonds and other forms of debt rather than sell equity or take out loans to finance growth. This more than doubled the market value of investment-grade (IG) bonds (debt rated AAA to BBB-), with corporations using the capital for acquisitions, share buybacks and dividend increases. Of this total, the lower-tier BBB segment jumped from nearly 31% to 44% of the overall IG market as measured the Bloomberg Barclays U.S. Credit Index (BBUSCI). Buyers starved for yield grabbed these bonds up.

To many, this has all the makings of a crisis—the market loves higher-yielding, lower-tier IG debt—until it doesn’t. And everyone knows the next step down in credit ratings puts BBB bonds in high-yield debt territory. But here’s the rub. In many cases, that step is a big one. When identified through active strategies that rely on experienced portfolio managers and analysts, this lowest rung of IG debt can be far from a reckless investment. For that matter, Moody’s reports that the average failure rate for all IG debt over the last 35 years is just 0.1%. Furthermore, less than a quarter of this tiny amount represented debt that had been downgraded to BBB. In other words, the majority of BBB debt has been issued by healthy companies—many in the strong sectors of banks, governments and technology—looking to grow and taking the most cost-effective means to do so.

Ultimately, a pessimistic view of BBB debt is really shorthand for thinking that the credit cycle is over and a recession is imminent. We don’t see signs of either. The macro picture has robust fundamentals, including impressive growth, robust business and consumer confidence and unemployment at 49-year lows. And the usual indicators of recession—a spike in high-yield defaults, an inversion of the broad Treasury yield curve and a jump in inflation—haven’t emerged.

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 and that it also may be nearing a pause in its rate-hike cycle, suggesting BBB corporate returns should remain competitive. The bottom line: a growing economy usually leads to reductions in leverage, and the lower corporate tax rate should lead to less debt issuance. Both are bond friendly. So, we remain modestly overweight IG credit, looking for opportunities to add as tactical play with confidence in our fundamental credit analysis.

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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.

Bloomberg Barclays U.S. Credit Bond Index is composed of all publicly issued, fixed-rate, nonconvertible, investment-grade corporate debt. Issues are rated at least Baa by Moody's Investors Service or BBB by Standard & Poor's, if unrated by Moody's. Collateralized Mortgage Obligations (CMOs) are not included. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indexes are unmanaged and investments cannot be made in an index.

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

High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risk and may be more volatile than investment-grade securities. For example, their prices are more volatile, economic downturns and financial setbacks may affect their prices more negatively, and their trading market may be more limited.

Federated Investment Management Company