Why quality matters when investing in corporate bonds
Risk has returned. Markets have roared back from the recession angst that characterised the final months of 2018.
During that stomach-churning episode we held our nerve as the available evidence suggested little risk of an imminent recession. Despite the v-shaped recovery in riskier assets, we still see equities outperforming government bonds. However, we think a cautious position in what we call equity-type risk is warranted, which includes most corporate bonds.
It may seem counterintuitive, given our preference for maintaining exposure to equities, but our analysis suggests it might be time to reduce exposure to the lowest quality investment grade corporate bonds (BBB rated) in favour of the safety of higher-quality debt (bonds with a credit rating of A to AAA). We classify these safer corporate bonds, or credits, as liquidity-type assets because they can more easily be sold in times of market turmoil.
The most anticipatory leading economic indicators are yet to send a recessionary signal as a group. However, the yields on corporate bonds with a BBB credit rating relative to US Treasuries reaches its trough on average eight to 12 months before a recession. That leaves less of a window between the early warning signals and the peak in credit markets (yields move inversely to prices) compared with equities.
Furthermore, the liquidity risk (the risk of not being able to sell an asset at a fair value or at all) has gone up in credit markets due to a number of structural changes following the financial crisis. We think it’s prudent to make the switch now, given this risk will only heighten when default rates pick up and there is an increase in the number of BBB bonds being downgraded to high yield, or non-investment grade (anything below BBB).
To be clear, the default rates implied by today’s valuations are still comfortably above average. But we see little scope for valuations to go higher, and do not feel that the additional yield you get from equity-type versus liquidity-type investment grade credit is enough to compensate for the extra risk.
What’s worse, the balance sheets underlying a disconcerting number of BBB issuers are looking weak. If economic conditions do deteriorate, some of these companies with high levels of debt and lower levels of cash flow for covering that debt could be in trouble.
Figure 3: Changing composition of UK corporate bond markets
The lowest-rated BBB credits have grown to roughly half of the overall investment grade market over the past decade
Source: Bank of America Merrill Lynch Sterling Corporate Bond Index and Rathbones.
Ringing the changes
We are concerned about some of the fundamental changes we’ve seen in the sterling-denominated corporate bond market over the past decade. For instance, the lowest rated BBB credits have grown to roughly half of the overall investment grade market, from just a fifth (figure 3). Some analysts would point to higher standards at the credit-rating agencies since the financial crisis.
Regardless of the causes of this increasing preponderance of BBB-rated debt, if there were a similar percentage of downgrades to what was experienced in the last recession, there would be far more debt for the high yield market to digest. That would exacerbate the liquidity issues discussed above.
The lowest-rated BBB segment has also grown substantially as a proportion of the euro and dollar investment-grade markets, which are both far bigger. In fact, both these markets have grown more substantially overall, meaning the absolute growth in their BBB segments has been even more significant.
This shift is the latest part of a wider reorientation towards favouring more defensive assets that we began last year. With the current spreads being, in our view, insufficient to justify the additional risk of equity-type over liquidity-type investment grade credit, we think the shift makes sense. In particular, we are wary of the growing liquidity risk we see in BBB corporate bonds, given the structural changes that have boosted this risk since the last recession.