By John Lloyd
The recent influx of BBB-rated debt has sparked fears that widespread downgrades could be imminent. Portfolio Manager John Lloyd explains why these concerns may be overblown and offers insight on how to identify opportunities in the sector.
The BBB category of corporate debt, which represents the lowest tier of the investment-grade market, comprises roughly half of the $5.4 trillion of investment-grade bonds in the U.S. The influx of BBB-rated debt in recent years has prompted fears that a large swath of companies is in danger of dropping out of the investment-grade pool into the "junk" bucket - fears that have been exacerbated as various economic signals suggest a recession could be looming.
While it is true that BBBs would be more vulnerable to downgrades than higher-rated securities in a risk-off environment, not all BBBs are the same, and it is important to recognize that certain industries and individual companies within the space may be more resilient in the face of economic challenges. We believe the concerns surrounding the sector are somewhat overblown for a number of reasons.
First, to accurately assess the BBB market, it helps to understand how debt markets grow. As companies generate more earnings, they can use the money to service more debt. While leverage has increased to peak levels, interest rates are extremely low. As a result, even as companies add more debt relative to their earnings, it is easier for them to cover the interest in this low-rate environment. In a recession, interest rates tend to remain low or even decline, so for companies with steady free cash flow, this dynamic would continue even in a downturn.
Second, it's important to consider the entire spectrum of risk that exists within the BBB space. Recent headlines would lead one to believe that massive downgrades are imminent across the entire sector. However, there is a wide disparity in default rates between an instrument that is rated BBB+ and one that is rated BBB-. The reality is that, within the multitrillion-dollar investment-grade universe, less than 3% of issuers are on the BBB- precipice of being downgraded to high yield. Careful analysis of the individual issuers is key to determining their ability to avoid rating-agency downgrades and weather a potential recession.
With that in mind, the third consideration when evaluating BBB debt is where the debt is coming from. A substantial amount of the BBB issuance has been generated by four main sectors: telecom, healthcare, food and beverage, and technology. Many of the issuers in these sectors have defensive business models, meaning their cash flow and earnings tend to be less negatively impacted by macroeconomic movements. Should the U.S. enter a recessionary period, healthcare companies' financials, for example, should remain relatively stable because consumers still require medical care during a downturn. The same can be said for certain segments of the telecom industry: If unemployment were to rise sharply, most out-of-work consumers would continue to pay their cellphone bills to facilitate job searches.
Lastly, a positive shift in company behavior is starting to emerge. After taking advantage of low interest rates to fund growth or extend maturities over the last few years, many BBB issuers are now focused on deleveraging their balance sheets. A closer look at the sector suggests that the outlook for BBB-rated debt is not as bad as it seems on the surface. However, considering the relative resiliency of a company's industry and focusing on those companies whose management teams have both the ability and willingness to delever are key to identifying opportunities in the sector.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
High-yield or "junk" bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.
Bond ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest).
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