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Beware the growing levels of debt just one step above ‘junk’

The proportion of corporate bonds rated just one step above so-called ‘junk’ status is reaching ever higher levels, which is potentially a huge problem for investors as and when the next recession hits

29/01/2019

Ben Arnold

Ben Arnold

Investment Specialist, Equity Value

The world of investment does not offer much in the way of certainties but one thing investors can be sure of is that markets do not head upwards indefinitely.

Another is that, as and when markets turn downwards, any attempts to explain why this has happened will provoke some to respond that it is easy to be wise after the event.

The thing is, in the context of potential threats to markets, it is easy enough to be wise before the event too, which is why, here on The Value Perspective, we highlight areas where risk is building up in the financial system – for example, in the case of covenant-lite and leveraged loans.

That said, hoisting a red flag over part of a minefield is not the same as knowing when – or even if – it will be the area that ultimately blows up.

Riskier, low rated bonds are being bought up

Take, for example, the way so-called ‘investment-grade’ credit indices are comprising ever-higher proportions of ‘lower-rated’ bonds – and specifically those classed as BBB by credit agencies, which is the category just above non-investment grade or, less politely, ‘junk’ bonds.

We flagged this as an issue in the context of UK bonds last year but, as the following chart shows, it just as big an issue across the Atlantic.

 

The Big Downgrade

Source: Bloomberg Barclays indices 2018 - orignially published on Bloomberg

 

As you can see, according to Bloomberg, BBB-rated bonds now make up more than half of all investment grade debt in the US, while issuance of bonds in that ratings band is some three times what it was just before the credit crisis really took hold in 2008.

Yet, for example, seven-year BBB-rated debt in the US is just 50 basis points more expensive than the debt of the top-rated AAA companies – the narrowest spread for years.

As you would expect, lower-rated businesses pay higher rates of interest to those prepared to take on the risk of buying their bonds but, equally, the more sought-after any asset is, the cheaper it becomes.

Income investors aren't being picky

Once again, then, we are in the realms of investors seeking out income without being terribly picky about where they find it. And, to a certain extent, that is fine … right up to the moment when it isn’t.

In the context of corporate bonds, that moment would be when companies can no longer pay what they owe, default on their borrowings and/or go bust.

On that point, it is worth noting that the last three US recessions saw between 7% and 15% of investment-grade debt downgraded and, while that was an issue then, it would be an even bigger problem now when so much of that debt is BBB-rated and the next step downwards is ‘junk’.

Clearly there is a significant risk, then, of any big financial shock or downturn leading to a huge de-rating of companies into ‘junk’ status, which would inevitably mean a spike in borrowing costs and therefore to overall running costs for these businesses – at which point everyone will be able to be wise after the event.

Author

Ben Arnold

Ben Arnold

Investment Specialist, Equity Value

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