Investment-grade debt is a cornerstone of institutional portfolios, yet the surge in borrowing during the Covid pandemic has raised questions over whether it is always the safer bet in the bond markets.
The level of corporate debt issuance has reached record highs. Indeed, during 2021 $118bn (£87bn) worth of debt was issued globally, according to Lipper Refinitiv, as companies scrambled to secure cheaper borrowing ahead of potential interest rate hikes.
It appears that corporates are expecting the cost of money to rise soon as in the first week of January north of $100bn (£73bn) had been raised. But coinciding with rising debt levels is a deterioration of credit quality in the investment-grade universe. The share of BBB rated bonds in this space has increased to 51% from 37% during the past 10 years, Bloomberg says.
This puts a large part of what is labelled the safest debt on the market in the firing line to potentially become fallen angels by losing their investment grade rating in favour of high-yield status. But emerging from this trend has been something of a paradox.
Bonds with a BBB rating, which have the prospect of becoming high yield, have seen an effective reduction of borrowing costs, despite a deterioration in their balance sheets, according to the Federal Reserve Bank of New York. “Prospective fallen angels paid 13 basis points less to borrow in the corporate bond market as compared with safer BBB-rated issuers,” the report said.
“If prospective fallen angels had been downgraded below the BBB rating, their funding costs would have risen by around $300bn (£221.6bn) over the period from 2009 to 2019.” A key reason for this paradox is, ironically, the central banks themselves. Their large-scale purchases of predominantly investment-grade debt have distorted yields. Another reason is the persistent institutional demand for highly rated debt, the New York Fed noted.
Alongside the surge in issuance and deterioration of quality, the duration of investment-grade debt increased significantly. It now stands at an average of eight years, while the typical duration of high-yield debt has remained relatively unchanged for the past decade, at an average of 4.5 years, according to MSCI.
Offering longer duration debt has been an attempt by issuers to make investment-grade yields more attractive to institutional investors. But this could backfire as inflation picks up. Bonds with a longer duration might be hardest hit when price levels rise. This could explain why investment-grade bond funds have seen larger outflows than their high yield counterparts. For example, the Lipper A-rated bond index is down -3.21%, year-to-date, while the Lipper High Yield Bond Fund Index has dropped by -2.18%.
Almost half of bonds held in defined benefit scheme portfolios are managed passively, according to Mercer’s Asset Allocation Survey. This adds another risk to the equation. In the event of an issuer downgrade, investors who track an index might become forced sellers just when the bonds have fallen in price. Examples include energy firms EDF and National Grid, which have been downgraded in the past year.
Another unintended consequence of these downgrades could be their impact on the composition of investment-grade indices, which risk becoming less diversified in terms of sectors and issuers. Afsaneh Mastouri, executive director of fixed income solutions at MSCI, acknowledges that individual issuer downgrades can affect sector composition. “Within sectors, you might see some changes in the exposure to single names.”
But she adds that the index provider aims to counteract this by following a barbell strategy in its index composition in sectors such as the energy sector. “We have big names that have quite high leverage and smaller companies which usually have a lower rating,” Mastouri added. “So, when we have seen downgrades, they have usually impacted the smaller companies.”
But there is an important counter argument to the theory that the lines between investment grade and high yield have become blurred. Default rates in high yield are significantly higher, as research by MSCI highlighted. The average default rate in high-yield debt is 20 times higher than that of investment grade, the authors point out. All this matters when markets are heading for the prospect of quantitative tightening.
Faced with rapidly growing inflation, the biggest buyers of investment-grade debt, central banks, have to come up with a timeline to reduce their balance sheets. The first on track to do so is the Bank of England, which has announced that it is to start selling its £20bn corporate bond portfolio.
The impact will be more severe when the European Central Bank and the Fed follow suit, as both hold far larger portfolios of corporate debt. When they do so, bond prices and yield spreads might say something meaningful about the health of the underlying companies. This brings to mind the Warren Buffet adage: “It’s only when the tide goes out that you learn who has been swimming naked.”