By Collin Martin
The investment-grade corporate bond market has gotten riskier.
BBB rated corporate bonds now make up more than half of the investment-grade corporate bond market,¹ and the share keeps rising. We suggest investors play defense with their investment-grade corporate bond investments, focusing on issues and investments that have higher average credit ratings.
Why defense makes sense today
After flirting with the 50% level for the past few years, the percentage of BBB rated bonds in the Bloomberg Barclays U.S. Corporate Bond Index jumped all the way to 52% in January 2019. That represents a large increase over the past 10-plus years, as they represented just one-third of the index in mid-2008.
BBB rated corporate bonds now make up more than half of the investment-grade corporate bond market
Source: Bloomberg Barclays Indices, using monthly data as of 1/31/2019. Credit rating breakdown is for the Bloomberg Barclays U.S. Corporate Bond Index. Past performance is no guarantee of future results.
Why does this matter? Not all investment-grade corporate bonds are created equal. Even within the investment-grade rating spectrum, the quality of the issuer can vary. Bonds can be rated as high as AAA/Aaa or as low as BBB/Baa by Standard & Poor's and Moody's Investors Services, respectively,2 and still fall within the investment-grade universe.
Per Standard & Poor's (S&P), "An obligation rated 'BBB' exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to weaken the obligor's capacity to meet its financial commitments on the obligation." 3
This poses a risk for those investors who use passive, index-tracking investments like exchange-traded funds (ETFs). If an underlying corporate bond index has more than half of its holdings rated BBB, it's likely that an ETF that tracks that index has a similar allocation. In these cases, investors are likely taking on more credit risk - that is, the risk an issuer will default on its payment obligations - than anticipated.
This makes it difficult for those who invest in individual bonds to find higher-rated issues. But it may be a benefit for existing bond holders. With fewer highly rated corporate bond issues today, other investors may pay premium prices to own them, keeping their prices supported.
How to play defense with individual bonds
One way to take a more defensive approach is to identify individual corporate bonds with relatively high credit ratings. One way to do that is to focus on sectors.
As the table below illustrates, some sectors have higher average credit ratings than others. Technology, consumer cyclical, utility, and financial institutions sectors all have average credit ratings that are firmly in the single-A area. Utilities tend to be highly regulated, which helps keep their revenues relatively stable and helps keep average credit ratings high. Financial institutions also have relatively high average ratings. In the post-financial-crisis era, more rules and regulations were put in place to help ensure that financial institutions have enough capital to better weather another crisis or sharp economic slowdown.
Meanwhile, the basic industry and communications sectors have average credit ratings that are firmly in the BBB area. The average credit rating of the basic industry sector has been Baa1/Baa2 for more than a decade. Meanwhile, the average credit rating of the communications sector has declined over the years - it was A3/Baa1 in mid-2014. That sector is dominated by a few large companies that have significantly increased their debt outstanding over the past few years.
(Note: The sector classifications used by the Bloomberg Barclays U.S. Corporate Bond Index differ from the Global Industry Classification Standard [GICS] commonly used for stock sectors. The filter criteria on Schwab.com uses the GICS classification, so the sectors listed below may not match exactly with the screening criteria available. For example, "basic industry" issues would generally fall under the "materials" GICS classification, while issues in the "transportation" and "capital goods" sectors would fall under the "industrials" GICS classification.)
Average credit ratings can vary by sector
Source: Bloomberg, as of 1/31/2019. Sectors represent the various sub-indexes of the Bloomberg Barclays U.S. Corporate Bond Index. Ratings use the Moody's Investors Services ratings scale, and the presence of two ratings indicates that the average credit rating falls somewhere between the two shown. Columns 1 represents the sector terminology used by the index, while column 2 represents the corresponding sector used on Schwab.com to screen for sectors, per the GICS classification.
Because a credit rating can be an indication of an issuer's health, the relative yields that a given issue or sector - the so-called "credit spread" - varies. A credit spread is the additional yield that corporate bonds offer above Treasury yields of a comparable maturity, and is meant to act as compensation for their greater risks. For example, the technology sector offers the lowest relative yields, likely due to the sector's high average credit rating of A2/A3.
You won't see a linear rise in credit spreads as you move from the highest-rated sectors (with lower perceived risks) to the lowest-rated sectors (with higher perceived risks). However, there are a few sectors that stand out, including the basic industry and communications sectors, which offer the highest relative yields. While higher yields may seem enticing, it's because those sectors come with increased risks today, as evidenced by their low credit ratings.
The energy sector stands out as well - at 149 basis points, its spread is well above similarly rated sectors. That's likely due to the large drop in crude oil prices from their October 2018 highs. Despite rebounding more than 25% from the late December lows, the price of West Texas Intermediate oil is still more than $20 below levels from early October.
While playing defense and focusing on higher credit ratings may mean accepting lower yields, higher-rated bonds tend to do better during bouts of market volatility or slower economic growth.
The highest-yielding sectors have the lowest average credit ratings, implying greater risks
Source: Bloomberg Barclays Indices, as of 2/4/2019. For illustrative purposes only. Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan. A basis point is 1/100th of a percentage point, or 0.01%.
When investing in individual bonds, also remember that not all BBB rated bonds are created equal either. A bond rated BBB-/Baa3 by S&P or Moody's, respectively, is just one notch above "junk" territory. A downgrade of just one notch would mean that the issuer would no longer carry an investment-grade credit rating, but instead a high-yield rating, with the resulting risk of further price declines. Keep in mind that the markets are forward-looking, and prices tend to decline before a downgrade actually occurs.
How to play defense when investing in funds
Investors who use passive, index-tracking investments like ETFs may want to consider actively managed funds. Ideally, we suggest investors identify funds that may have lower allocations to the BBB part of the market than what the index provides - preferably less than half.
While an active bond mutual fund doesn't mean the fund manager focuses on the higher-rated parts of the market, this at least allows the fund manager to decide what to own - and sometimes more importantly, what not to own. Sometimes avoiding a risky bond issue or multiple bond issues can be just as important as identifying potential bonds to actually invest in.
Another way to focus on higher average credit ratings may be to simply pare your corporate bond holdings and reinvest the proceeds into higher-rated bonds like U.S. Treasuries or highly rated municipal bonds. For more conservative investors, a corporate bond fund with a more than 50% allocation to BBB rated bonds may be too much exposure to the riskier parts of the market.
What to do now
Consider moving up in credit quality in the investment-grade corporate bond market, identifying investments that focus more on A-and-above-rated securities. While this may mean lower relative yields and lower income, it could result in less downside risk during periods of market volatility or if the economic outlook deteriorates.
1. Based on amount outstanding of the Bloomberg Barclays U.S. Corporate Bond Index, as of 1/31/2019.
2. S&P ratings from 'AA' to 'CCC' may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the rating categories. Moody's appends numerical modifiers 1, 2, and 3 to each generic rating classification from Aa through Caa.
3. S&P Global Ratings, "S&P Global Ratings Definitions," October 21, 2018.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.