A growing concern in the corporate bond universe is the massive amount of BBB-rated debt that could be vulnerable to downgrades to junk status in the months ahead. Currently, a significant percentage of the U.S. corporate bond market has a BBB rating of some kind, meaning those bonds are within one to three notches of junk status.
Fundamentally-weighted corporate bond exchange traded funds, such as the WisdomTree Fundamental U.S. Corporate Bond Fund (BATS:WFIG) and the WisdomTree Fundamental U.S. Short-Term Corporate Bond Fund (BATS:SFIG), can help investors position in higher quality corporate bonds.
"While the benign credit environment of recent years may be softening, we believe domestic economic strength will continue to support corporate profitability and solvency in quality companies," said WisdomTree in a recent note. "However, companies with weaker fundamentals could be more vulnerable to downgrades as rates rise. In our view, prudent investors should start to assess whether the underlying credit risks in their portfolios are worth taking."
Inside WFIG ETF
WFIG, which has an effective duration of just under seven years, tracks the WisdomTree Fundamental U.S. Corporate Bond Index (WFCIG). That benchmark focuses on quality companies with attractive income potential. Nearly 41% of the bonds in that index are rated AA or A.
"A key difference between WFCIG and the ICE BofAML U.S. Corporate Index is that fewer bonds in WFCIG have been downgraded to non-investment-grade or junk status," said WisdomTree. "When companies lose their investment-grade rating, many managers may be forced to sell these positions, according to their investment policy statements. As a result, these bonds often underperform in the short run after being downgraded."
WisdomTree has identified deteriorating cash flows, rising leverage and weakening profitability compared to peers as effective markers for potential credit concerns. WisdomTree believes eliminating these issuers can generate a considerable improvement in the strategy's downside risk protection.
If a spate of investment-grade-to-junk downgrades ensues, WFIG could be well-positioned to endure that storm.
"As of the end of September 2018, only 0.67% of the investment-grade index was downgraded to junk status over the trailing 12 months," according to WisdomTree. "Put another way, this period ranks in the 90th percentile among the most benign periods in the last 20 years. In our view, should the current trend begin to normalize, the WisdomTree Fundamental U.S. Corporate Bond Index could provide a defensive stance to better weather the performance impact of bonds falling to junk."