With growing reports of potential increased downgrades of BBB bonds, David Thornton, senior investment manager, Premier Multi-Asset Funds, explains what he believes investors should be considering in their bond portfolios.
There has been lots of coverage about the growth in issuance of BBB rated bonds and a potential impending wave of BBB bond downgrades. About 50% of both the sterling and global investment grade market is BBB so this is an important question for advisers to consider for their clients’ portfolios. I believe that whether there are increased downgrades or not, many investors are missing the real risk on their BBB investments – which is the risk of widening spreads, and divergence of spread between BBB and higher rated bonds and the risk of losing money.
One of the arguments supporting more BBB downgrades is the amount of leverage in these bonds, and the fact that leverage is a key drivers of downgrades. Some will argue that leverage alone is too narrow a measure to identify potential downgrade candidates and that there is little relationship between leverage and returns. That appears to be more or less correct looking across long time periods, as high leverage in itself is often not an issue whilst credit conditions remain favourable. But the risks of high leverage can be a real problem if economic conditions deteriorate.
Leverage in investment grade bonds has been reducing although the decrease is marginal. The simple fact remains that lower earnings translate into higher leverage which means the biggest increases in leverage usually occur during a recession. The concern is that leverage is already around peak levels seen in previous cycles, and that is in the current ‘healthy’ economy.
Ratings agency views towards balance sheet leverage have become more lenient as the cycle has matured, often giving credit for very optimistic forecasts. However, company debt reduction targets have rarely been met in a timely manner, often as a result of over optimistic future earnings assumptions, at a time when economic and financial conditions are a tailwind. Things can, and I believe will, get worse.
One of the arguments against the potential for more BBB downgrades is that many investment grade companies have several levers to pull in order to manage their debt through the cycle in order to retain their investment grade status. These measures typically involve cutting dividends, selling non-core assets or layering in secured debt. But this type of action to reduce debt to retain a rating often happens when a management team’s hands are forced by the markets and as an investor, there are plenty of reasons why you might not want to be left holding those companies. Dividend cuts and asset sales can fundamentally change a company’s financial appeal.
When forced deleveraging comes along, as surely it will, it rarely happens in a smooth or painless manner. The financial world is nothing, if not fickle. Where once shareholder friendly activity was the order of the day, balance sheet quality can quickly become the sole focus, and in this environment, BBB bond holders face the prospect of losing money on their investment.
So a debate about a potential wave of downgrades is interesting but in my view misses the point. If earnings drop and a company is forced into action to retain its BBB rating, it’s likely this is a company’s bond you don’t want to own today. Downgrade or not, spreads will be wider. And in a broader market context, this trend of protecting investment grade bond status could result in a significant spread gap opening up between those BBB rated companies that cannot address a deterioration in fundamentals and their more highly rated siblings.
The last quarter of 2018 gave a good insight into how a turn in the credit cycle could look. What was once abundant liquidity in a bull market can very quickly disappear. Fear takes a grip, selling momentum builds and in the liquidity vacuum, prices can fall significantly lower. Corporate spreads widen sharply. This is obviously bad news for BBB bond investors.
And this is why in Premier’s multi-manager, multi-asset portfolios we are significantly underweight in vanilla investment grade bonds, including BBB bonds, and are focusing our fixed interest exposure instead in other areas, including mortgage backed securities and other asset backed securities, where we see better value and a better risk and reward trade-off for our clients.
