Federal Reserve voices fears about credit quality in the investment-grade bond market
- Low interest rates led companies to pile on debt for M&A, and the amount of debt rated in the lowest tier of investment grade is near a record, representing roughly 35 percent of corporate bonds and more than $2 trillion.
- While many bond experts do not believe a systematic risk is imminent, the Federal Reserve twice this week issued warnings about the corporate debt market.
Fears about credit quality in the investment-grade bond market have been mounting for months. This week the Federal Reserve added its voice to the ranks of the concerned. In its first-ever Financial Stability Report and, later in the week, in the notes from its most recent Federal Open Market Committee meeting, the Fed cited conditions in corporate bonds as among the major risks for the U.S. economy and markets. And the Fed expressed more concern about investment-grade than high-yield, or junk, bonds.
Investment-grade bond funds and ETFs are among the largest used by individual investors. The iShares iBoxx Investment Grade Corporate Bond ETF (LQD), which is the third-largest bond ETF, at near-$30 billion, has roughly 50 percent of its portfolio in the lower tier of investment-grade bonds. The Vanguard Intermediate Term Corporate Bond ETF (VCIT), which has over $18 billion in assets, has more than half of its holdings in these lower-rated bonds.
These index funds aren’t taking excessive risk; they merely match the indexes on which the strategies are based. It’s the underlying investment-grade bond index itself that has seen a ballooning in lower-quality issues as the era of low interest rates led more companies to pile on debt for M&A and refinancings, and investors to price deals attractively.
“When you look at the numbers, it is huge,” said Erin Lyons of fixed-income research firm CreditSights. “The index has gotten so big, there is so much debt out,” Lyons said, referring to the more than $6 trillion in corporate bonds. As CNBC reported in October, there are only two corporate issuers rated AAA in the United States — Microsoft and Johnson & Johnson — and bonds rated BBB, the lowest rating of the investment-grade market, account for 50 percent of the Bloomberg Barclays investment-grade bond index, versus 38 percent prior to the financial crisis.
What the Fed said
In its Financial Stability Report, the Fed noted that the share of investment-grade debt classified at the low end of the range has “reached near-record levels” of $2.25 trillion, or about 35 percent of total corporate bonds. The Fed’s analysis of balance sheets at companies with debt in this rating tier indicated that over the past year, it has been firms with high leverage, high-interest expense ratios, and low earnings and cash holdings that have been increasing their debt loads the most. The report also warned of a potentially “large plunge in asset prices” and indicated that financial distress could “‘trigger a broad adjustment in prices of business debt,” with investors taking “higher-than-expected losses.”
In the minutes from its Federal Open Market Committee, the central bank said several of the FOMC members were concerned about “the high level of debt in the nonfinancial business sector.”
Many fixed-income investors have been focused in recent years on duration risk: As the Fed began to raise rates and send bond prices down, investors fled from longer-dated bonds. Credit-quality concerns, meanwhile, were centered on areas of the bond market known to be more risky, such as high-yield and emerging markets. But the Fed noted that the credit quality of nonfinancial high-yield corporate bonds has been roughly stable over the past several years, as ratings among investment-grade corporate bonds has deteriorated.
“So even if a severe economic downturn does not appear to be on the horizon, investors need to be aware of credit risks associated with their investment-grade bond ETFs, in addition to duration risk,” said Neena Mishra, director of ETF research at Zacks Investment Research. She said that while the economy is growing at a healthy pace, as of now, and risks of a recession in the near term appear to be low, the surge in issuance of bonds rated BBB has become a serious concern. In the event of a downturn in the economy, we could see a wave of downgrades to junk status from the lowest investment grade.
The composition among ETFs “looks worse” for intermediate-term investment-grade bond ETFs, such as Vanguard’s VCIT and the $5.5 billion iShares Intermediate-Term Corporate Bond ETF (IGIB), which have about 54 percent of their portfolio invested in BBB/Baa rated bonds, making them most vulnerable in the event of even some of these bonds falling to high-yield status.
“These ETFs would have to dispose of those fallen angels, further exacerbating the price decline and leading to a lot of volatility,” Mishra said.
The Fed noted in its report that in an economic downturn, “widespread downgrades of these bonds to speculative-grade ratings could induce some investors to sell them rapidly, because, for example, they face restrictions on holding bonds with ratings below investment grade. Such sales could increase the liquidity and price pressures in this segment of the corporate bond market.”
But the central bank also stated, “With interest rates low by historical standards, debt service costs are at the lower ends of their historical ranges, particularly for risky firms, and corporate credit performance remains generally favorable.”
Lyons at CreditSights doesn’t see systematic risk to investment-grade bonds right now, though she remains concerned and stressed that the issues go beyond any single stock that has made headlines for deterioration in credit quality, such as GE or Pacific Gas & Electric. “The amount of debt is getting bigger and bigger, while the ability to trade is diminishing. We are getting more cautious,” she said.
A BlackRock spokeswoman said to the extent that there are downgrades from BBB to high yield, those bonds would be gradually removed from the fund, and the risk to investors is potential credit losses associated with BBB downgrades as they are sold from the fund overtime. But she noted that LQD holds over 1,900 bonds, 390 distinct issuers and a 3 percent issuer cap, so it is well diversified.
Vanguard could not provide a comment by press time.
Lyons said CreditSights is not presently of the belief that the cracks in the BBB bond class are widespread, but there will be specific sectors represented within it where more stress should be expected. “I’m not that worried about a massive wave of downgrades,” she said.
What could change that view, however, is if ratings agencies decide to react by changing the terms for investment-grade ratings. “They’ve given companies a lot more leeway,” she said, and widespread downgrades could occur if the ratings agencies decide to become more stringent. It has happened before, and recently, with the energy sector being downgraded in early 2016 by the rating agencies. Though Lyons added, “I’m not seeing anything breaking the fundamentals of corporates. They are slowing, but not to the point where I am worried about defaults. It comes back to the agencies and slowing growth and how they react to it.”
No time to panic
It is inevitable that some BBB-rated credits fall to high yield, but the risk is not systemic, according to several bond experts. And since a significant portion of the BBB universe wants to preserve their current rating, companies may choose to make other moves rather than face a downgrade, such as dividend cuts, cutting share repurchase programs and M&A, which would have greater consequences for the company’s stock price.
Investment-grade bonds already are facing their worst year since 2008, and Lyons said investor sentiment remains the biggest risk for 2019. If nervousness wins and investors decide to reduce risk across the board, the outcome for investment grade remains uncertain. It could benefit in the sense that investors moving up from high yield would prefer investment-grade issues, but investment-grade prices already have fallen this year among broader equity and bond market repricing caused by investor skittishness, so a positive result is not assured. “Investors should be concerned. Investors feel like they should get better compensation for the risk,” said Lyons.
It isn’t a “canary in the coal mine” panic about the whole sector and “whole ratings bands blowing up and disappearing,” Lyons said, but more of a valuation question. For the moment, investor nervousness seems to have settled compared to earlier this month, when Guggenheim Partners Chief Investment Officer Scott Minerd tweeted that “the slide and collapse in investment grade credit has begun.” More recent bond deals have been closed at better pricing.
The BlackRock spokeswoman said investors looking to move up in credit quality within their corporate bond portfolios can consider other corporate bond ETFs, such as QLTA, where 98 percent of the fund is held in issuers rated Single A or above.
“Many investors don’t realize the credit risk their bond funds incur,” said Todd Rosenbluth, head of mutual fund and ETF research at CFRA. Active bond ETFs, which have become more popular as investors seek higher yield and stronger returns, such as the Pimco Enhanced Short Maturity ETF (MINT), iShares Short Maturity Bond (NEAR) and the JP Morgan Ultra-Short Income ETF (JPST), have some exposure to A or BBB bonds. That makes them riskier than ultra-short bond ETFs like iShares Short Treasury Bond (SHV) or iShares 1-3 Treasury Bond (SHY), yet given the low duration, the risk is largely mitigated, Rosenbluth said. Active core bond mutual funds tend to have a slice of lower-rated investment grades and are riskier than the aggregate bond index replicated by the iShares Aggregate Bond Index ETF (AGG). Credit risk was more rewarding in the past, Rosenbluth said, but a higher credit rating aided by more government bonds has proved helpful for AGG investors more recently.
Investors should not panic, but they do need to invest with eyes wide open. “Most investors think a bond fund is a bond fund; safe, sound, and stable. Already bond funds this year are not only performing worse than the S&P 500, some widely held ones are down by double-digit percentages,” said Mitch Goldberg, president of investment advisory firm ClientFirst Strategy.
“If the economy goes into a recession, defaults and debt rating downgrades should be expected to ramp up.” Chasing better yields has been popular in the era of low interest rates, but Goldberg said retail investors should wake up to the risks of continuing to think that way. “It’s important for investors to check what kind of bond fund or ETF they own and see what’s in it. It may be better to move money into a choice with lower-yield but higher-credit quality. Remember, one of the reasons to invest in bonds is for a return of your money in addition to a return on your money.”