Why bond investors should watch out for fallen angels

A larger portion of the investment-grade universe face a risk of being relegated to junk-bond status

Why bond investors should watch out for fallen angels

While those who seek fixed-income exposure in their portfolios are famously concerned with yield, their choices are also affected by a host of other variables. Among those is credit quality, as reflected by the rating assigned to an individual bond issuer or portfolio of bonds.

Generally, those who buy investment-grade securities should be confident that they face lower risks of default. But as Karen Schenone, Fixed Income Product Strategist at BlackRock noted in a recent commentary, a growing sub-segment of bonds has elicited concern among investors.

“Over the past several months, I have been fielding more questions about the state of the BBB-rated bond market,” Schenone said. “[I]nvestors are concerned about the potential for a large amount of bonds being downgraded to junk, a status known as ‘fallen angels.’

Based on an analysis of the Bloomberg Barclays Global Aggregate Corporate Bond Index, she found that BBB-rated bonds have grown from representing just 17% of the investment-grade market in 2001 to over 50% of the market today. U.S.-related BBB corporate debt, she added, has more than doubled over the past decade, with US$1.2 trillion of net new issuance and US$745 billion of issues downgraded from a higher credit quality, to reach US$2.5 trillion.

But even with the increase issuance of riskier debt in the investment-grade space, credit spreads have not widened. Schenone cited several global factors weighing on spreads, including a willingness among yield-seeking investors in the U.S. to consider BBB bonds and demand from foreign investors who face even lower — and in some cases negative — yields in their own bond markets.

“Given that rating downgrades tend to coincide with recessions, a more recent concern among investors has been whether the BBB sector is poised for significant downgrades into high yield territory,” she said.

Given how the credit cycle has been stretched by economic growth that’s come in part from central bank stimulus, Schenone said there could be a risk for highly levered or cyclical credits. But she added that certain issuers will be able to defend their credit ratings.

“[M]any BBB companies have tools at their disposal to keep their investment grade standing,” she said, citing measures such as cutting or eliminating stock dividends, share repurchase programs, or M&A activities.

Many companies, she added, have issued longer-dated bonds, which allow them to lock in low borrowing costs and provide a buffer against refinancing risks going forward.

One way for investors to sidestep downgrade risks to their bond portfolio, she said, is through the use of investment-grade bond ETFs. Most such funds seek to track an index that determine a bond’s rating based on assessments from multiple ratings agencies; bonds that get downgraded to BB+/Ba1 or below by multiple agencies are typically considered as high-yield or junk debt, and are subsequently removed from the index at the end of the month.

“The ETF’s portfolio manager will also seek to remove the bond from the portfolio and obtain best execution for the fund,” she added.


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