A prospective wave of “falling angels” – bonds originally issued at investment grade that have downgraded to junk — has many fixed-income ETF investors wringing their hands.
The low-interest-rate environment of recent years prompted many US companies to take advantage, funding a record number of mergers and acquisitions with corporate debt issues. But according to a growing chorus of analysts, the end of the credit cycle is nigh, and credit quality is on the decline.
“In fact, half of the Bloomberg Barclays investment-grade bond index comprises BBB-rated bonds, one step away from high yield; that’s nearly double the level of the 1990s,” wrote Diana Britton, managing editor of WealthManagement.com.
Citing Moody’s, Britton said the number of US companies in danger of becoming fallen angels — Baa3-rated names that either have a negative outlook or are on review — rose from 42 in the second quarter last year to 47 in the third. The debt of such companies also reached US$102 billion in the third quarter, its highest level since Moody’s started tracking the number in 2014.
For some, those numbers are flashing signs for fixed-income ETFs. “The border between investment grade and high yield has been recognized in the marketplace as a weak spot for passive managers, because they're really obliged to sell something that's had a downgrade,” said FactSet Vice President and Director of ETF Research Elisabeth Kashner.
But contrary to popular belief, taking bonds in and out of a portfolio is par-for-course for many managers even without the forced sale of bonds at depressed prices. “If you are a fixed income portfolio manager … you expect those adjustments pretty much on a monthly basis,” Kashner said.
According to Steve Laipply, head of U.S. iShares fixed income strategy at BlackRock, asset managers aren’t strictly bound to wait until the last day of the month to rebalance. Rather, their role is to “understand market conditions and to make a decision on what would be the most optimal time to sell.”
Josh Barrickman, head of fixed income indexing Americas at Vanguard, added that unlike equity ETF managers, bond managers buy just a sample of the market to replicate the underlying factors — duration exposure, credit spreads, and sector and industry exposures — of the index they’re tracking. That gives them elbow room to come up with samples with the least amount of downgrades; a good analyst, anticipating a bond to be downgraded in three to six months, can start to build an underweight to that name ahead of time.
“[In 2015 and 2016], I think the performance of the investment grade ETF actually was fairly good … and there were some pretty large issuers in those spaces that moved down to high yield,” said Francis Rodilosso, head of fixed income ETF portfolio management at Van Eck. And while around one eighth of the US$800-billion BBB universe is on negative watch by the ratings agencies, those volumes aren’t significantly higher than in the past.
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