Investment-grade bonds are supposed to be a port in the storm when the financial environment gets rough. Not so this year.
Other than emerging market bonds, U.S. investment-grade debt has had the worst performance of any major sector of the fixed-income landscape so far this year. The iShares iBoxx $ Investment Grade Corporate Bond ETF, a $34 billion fund tracking the U.S. corporate investment-grade market, was down 5.79 percent for the year through Oct. 2.
Rising interest rates are to blame. With the Federal Reserve Bank continuing to hike the short-term fed funds rate, longer-duration investment-grade bonds with historically low yields have suffered.
"The hit from interest rates has been a big deal," said Elaine Stokes, a fixed-income strategist and manager of several bond funds at Loomis Sayles. While the spread between investment-grade bonds and the 10-year Treasury has widened from 90 basis points in early February to as much as 130 in July, she doesn't think that represents a buying opportunity.
"The spread is still not very attractive," said Stokes. It currently stands at 113 basis points. "The yield and credit spread curves are too flat," she added. "You're not getting paid enough to go down in quality or longer in term."
Investment grade is also not what it used to be. There is widespread concern that the sheer volume of debt issued by investment-grade companies since the financial crisis could be a problem when the economic cycle turns. Corporate investment-grade bonds now total roughly $6 trillion, versus just $2 trillion before the financial crisis. Some of that is a result of economic growth, but corporate leverage by all measures is much higher than it was in the last cycle.
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The ratings distribution of the market is also far more skewed to the lower end of the scale. There are only two corporate issuers in the United States — Microsoft and Johnson & Johnson — rated AAA, and bonds rated BBB, the lowest rating of the investment-grade market, account for 50 percent of the Bloomberg Barclays investment-grade bond index, versus 38 percent prior to the financial crisis.
"Leverage is way up," said Erin Lyons, U.S. credit strategist for CreditSights. "The concern is over how much riskier BBB bonds are now."
"Some think many of them shouldn't have investment-grade ratings."
As borrowing costs rise with interest rates and the economy slows, there could be a wave of so-called fallen angels from the lower end of the investment-grade spectrum. That in turn would cause an exodus of institutional investors who don't invest in junk bonds.
On the positive side, the carrying cost of debt is far lower than in previous cycles. With the Fed's ultralow interest-rate policy since the financial crisis, investment-grade coupons in many cases are less than half what they were before the crisis. Companies have understandably loaded up on cheap money. With the strong U.S. economy, the ability of companies to shoulder higher leverage has increased.
"We're in the late stage of the cycle, but there's still good profit growth and debt coverage," said Karen Schenone, fixed-income strategist for BlackRock. "Rates are still low, and liquidity is high."
"The global [quantitative easing] has extended the cycle," she said.
Notwithstanding the late-stage stimulus from President Donald Trump's tax cuts and increased government spending, the credit cycle has not been banished. When the economy turns, the increased debt loads will become harder to carry for companies.
"The economy and companies are doing really well, but every quarter brings us closer to the end of the cycle," said Creditsights' Lyons. She expects spreads on investment-grade debt to remain fairly stable through the rest of the year, but like Stokes she doesn't think investors are compensated adequately for taking on duration and credit risk in the investment-grade space at this stage. She favors shorter-term bonds from higher-quality credits.
"Investors don't need to buy everything in investment grade," Lyons said. "You can be more selective."
Leverage is way up. The concern is over how much riskier BBB bonds are now. Some think many of them shouldn't have investment-grade ratings.Erin LyonsU.S. credit strategist for CreditSights
Her other major concern for heavily indebted companies is refinancing risk. Much of the money raised by investment-grade corporates has been used to buy back shares and distribute dividends to investors. Many others are using debt to finance very highly valued acquisitions. While corporate cash balances have grown with the buoyant economy and debt durations have been extended by companies, many will face a more difficult financing environment as their low coupon debt rolls off.
"There's roughly $600 billion in corporate bonds maturing in each of the next four years," said Lyons. While there has been ample investor demand for corporate debt, the terms are likely to deteriorate for companies going forward. If that happens, sectors with shorter-length debt maturities, such as the automotive, banking and financial services industries, will face much higher borrowing costs — and greater financial stress — in the future.
Schenone is positive on high-yield debt because of the better yields and generally shorter durations of junk bonds, but thinks investors should be cautious with investment grade bonds. For conservative investors, she suggests that a fund such as the iShares AAA-A Rated Corporate Bond ETF, which invests only in the highest-rated corporate bonds, is a good option. She also suggests investors stay short on the duration curve.
"At these yield levels, investors should stick to the shorter maturities," said BlackRock's Shenone.
