A huge swath of the corporate bond market is looking increasingly vulnerable.
Bonds with the lowest investment grade have been a market darling over the past decade, ballooning in size as low global interest rates drew fund managers seeking higher returns. But as borrowing costs climb to a four-year high just as investors begin to anticipate a downturn in the global economy, some analysts are starting to sound the alarm.
“We’re late in the credit cycle, and trying to figure out when everything turns,” said Erin Lyons, a senior credit strategist at New York-based research firm CreditSights Inc. “Some of these may eventually be downgraded.”
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Notes in the lowest rungs above high-yield junk — in the BBB group from S&P Global Ratings or the Baa bucket from Moody’s Investors Service — total about $3 trillion, almost the size of Germany’s gross domestic product. The concern is that as rates rise it will cost companies more to roll over their obligations, and if earnings begin to slump as economic growth slows, that could blow out leverage ratios and lead to credit-rating cuts.
The high-grade bond market in the U.S. already has the lowest credit quality mix since the 1980s, according to CreditSights, and there are signs investors are getting nervous. A Bloomberg Barclays gauge of average corporate bond spreads has surged to a six-month high since reaching an all-time low in early February.
“We’re wary of companies that have seen their debt-to-equity ratios deteriorate,” said Tim Ng, the chief investment officer at New York-based Clearbrook Global Advisors, which advises on US$28 billion of assets. “As interest rates increase, if they go too high, the higher debt-to-equity ratios and leverage will have a negative effect on cash flows.”
The big push into the bottom end of high-grade bonds was driven by the search for yield amid record-low rates following the 2008 financial crisis and unprecedented stimulus from central banks. Investors who were comfortable in A-rated bonds moved to BBBs, and those who were comfortable in BBBs dipped into high yield, according to Lyons of CreditSights.
“What happens when that all retraces?” she said.
A hint of the potential turmoil ahead came from Teva Pharmaceutical Industries Ltd. earlier in the year. The drugmaker’s bonds were cut to junk from investment grade by Moody’s after its US$41-billion buyout of Allergan Plc’s generics business in 2016 left the company with a debt load that outweighed its value in the stock market.
So far, the jitters among investors haven’t translated to dramatic price drops or much hesitation to take down new debt. Yield spreads on investment-grade corporate bonds are still less than half of what they were in early 2016, and a recent deal that relied on the BBB market for funding — Syngenta’s US$43-billion takeover by ChemChina — was gobbled up by investors. And, according to Lyons, the tier also offers a healthy mix of players that helps counter any concerns.
But for bond investors worried about higher interest rates and increasing leverage, the best bet might be to leave the lowest-rated investment-grade debt and move into the top-rated securities, according to Hozef Arif, a money manager at Pacific Management Investment Co., which oversaw US$1.77 trillion in assets as of March 31.
“If you are indeed concerned about the late credit cycle,” Arif said, “you probably want to be up in quality. It’s somewhat more defensive in case credit conditions begin to degrade.”