By Karen Schenone, Fixed Income Product Strategist, BlackRock.

How risky are BBB bonds?

Over the past several months, I have been fielding more questions about the state of the BBB-rated bond market. (BBB is the lowest tier of investment grade.)

As this credit cycle has lengthened, investors are concerned about the potential for a large number of bonds being downgraded to junk, a status known as “fallen angels.” In this post, I’ll assess the risks of this growing market and how investors can position for a potential downturn.

Growth of the BBB bond market

Over the past decade, the investment-grade corporate bond market has grown as issuers have taken advantage of rock-bottom interest rates and increased demand from yield-starved investors. Today, the BBB-rated segment now makes up over 50% of the investment-grade market versus only 17% in 2001. Over the past decade, US-related BBB corporate debt has grown 2.2x to $2.5 trillion, representing $1.2 trillion of net new issuance and $745 billion of downgrades from a higher credit quality.

Source: BlackRock.

Credit spreads, or the additional yield investors receive above Treasury bonds, have not widened, even as more debt has been issued. (Widening spreads point to increased risk expectations.) This is due to a number of global factors. In the US, after years of near-zero interest rates, investors are searching for yield, making them look at lower-quality investment-grade securities like BBB bonds. At the same time, foreign investors have been drawn to US corporate bonds, which continue to see solidly positive yields, as other developed markets are seeing negative bond yields.

Source: BlackRock.

BBB downgrade risk: Is a wave of fallen angels on the horizon?

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. While central bank stimulus is stretching the credit cycle by spurring economic growth, highly levered or cyclical credits could be at risk.

However, some issuers will be able to defend their credit ratings. First off, many BBB companies have tools at their disposal to keep their investment-grade standing. For example, they can cut or eliminate stock dividends, share repurchase programs, or M&A activities. Kraft Heinz Foods suspended its dividend in February 2019 after poor earnings to ensure timely payment of their BBB-rated bonds. Additionally, many companies issued longer-dated bonds, locking in low borrowing costs and reducing refinancing risk going forward.

How a bond ETF deals with downgrades

Most investment-grade bond ETFs seek to track an index from providers such as Bloomberg Barclays, ICE, or Markit iBoxx. These providers determine a bond’s rating by using a blend of ratings from Moody’s, S&P and Fitch. Typically, if a bond gets downgraded by multiple rating agencies to BB+/Ba1 or below, then it will be considered high yield or junk, and the index will remove it at the end of that month.

The ETF’s portfolio manager will also seek to remove the bond from the portfolio and obtain best execution for the fund. The portfolio manager can choose when to trade the bond and they are not forced to trade on month-end. But they will remove the bond so over time an investment-grade fund will remain that way.

ETF implementation ideas

Investment decisions around the risk of BBB downgrade, then, will depend on your view on the likelihood of the US entering a recession versus the need for yield in your portfolio. Below are three bond ETF strategies to consider:

• Avoid BBB-rated corporate bonds with iShares Aaa – A Rated Corporate Bond ETF (QLTA US). QLTA holds only AAA-A corporate bonds.
• Seek higher-quality investment-grade bonds with iShares Edge Investment Grade Enhanced Bond ETF (IGEB US). IGEB is a corporate bond fund that uses fixed income factor insights to screen out lower-quality and overvalued bonds, potentially mitigating BBB downgrade risk.
• Seek growth opportunity from a potential fallen angels premium with iShares Fallen Angels USD Bond ETF (FALN US). Bonds tend to experience significant price declines when they are first downgraded, yet over time fallen angel issuers have tended to outperform the broad high-yield market as they rebound from being oversold and undervalued.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)