Viewpoints

Investment Grade Credit: Be Actively Aware of BBB Bonds

Room for error is narrowing for investments in the lower tiers of the U.S. investment grade corporate bond market.

The U.S. corporate bond market is a massive, diverse asset class that has seen decades of significant growth. In the past four years alone, the market has increased from around $4 trillion to $5.8 trillion. This growth, however, has been accompanied by a steady decrease in overall credit quality. Investors should watch this trend closely, especially when weighing the potential risks and benefits of passive versus active management in their credit portfolios.

Crucially, the share of the U.S. investment grade (IG) nonfinancial bond market that is rated BBB (i.e., the lowest credit rating still considered IG) has increased to 48% in 2017 from around 25% in the 1990s. Drilling down into the riskiest part of the BBB market segment, the universe of low BBB rated bonds is now bigger than that of all BB rated bonds (i.e., the highest-rated speculative grade bonds) combined. (Read our investor education piece on corporate bonds for a quick refresher on credit ratings, issuers, credit spreads, risks and reasons to invest.)

Average credit fundamentals also declining

Back in 2000, net leverage of BBB rated nonfinancial corporates was 1.7x on average; in 2017, net leverage for these companies was 2.9x (see Figure 1; net leverage is defined as (total debt – cash – short term investment) / EBITDA (i.e., earnings before interest, taxes, depreciation and amortization)). This suggests a greater tolerance from the credit rating agencies for higher leverage, which in turn warrants extra caution when investing in lower-rated IG names, especially in sectors where earnings are more closely tied to the business cycle.

Figure 1 shows a graph of net leverage of U.S. investment grade credit from 2000 to 2017. Over the time period, BBB rated credit has higher leverage levels that that of A rated credit, and peaks on the graph around a ratio of 3.25 in 2016. A rated credit around that time was near a ratio of 1.80. Both in 2017 were just off those highs for the time period.

The higher leverage among U.S. investment grade issuers should also be seen in context: Back in 2010, only 6.6% of the IG nonfinancial market had net leverage greater than 4.0x, but as of 2017, that share increased to 19% (see Figure 2). In addition, only 26% of IG nonfinancial debt is leveraged less than 2.0x as of 2017, compared with 55% in 2010.

Figure 2 is a bar graph comparing the percentage of investment grade debt in five different ranges of leverage ratios. The ranges of ratios are zero to 0.99, 1.00 to 1.99, 2.00-2.99, 3.00 to 3.99, and 4.00 and higher. The bars contrast the third quarter of 2010 with the second quarter of 2017, showing leverage shifting towards the higher ranges of 2.00 and up over the period.

Average interest rate coverage for BBB issuers has improved since 2000, to 8.2x from 5.3x, due to record low interest rates (see Figure 3). That said, interest rate coverage has actually been deteriorating overall in the past few years; it reached 11.4x in 2013.

Figure 3 shows a graph of the average interest rate coverage of U.S. investment grade credit, from 2000 to 2017. Average interest rate coverage for BBB issuers has improved since 2000, to a ratio of 8.2, up from 5.3. Yet the chart also shows how overall interest rate coverage has declined to ratio about 11 in 2017, down from about 14 in 2013.

These negatives are partially offset by average net-debt-to-enterprise values. On that basis, the credit deterioration has been significantly less pronounced: Average net debt/EV has gone from 23.9% 10 years ago to 26.8% five years ago and 29.5% in 2017, attributable to supportive equity prices. This is an important consideration given the strong historical correlation between credit spreads and net debt/EV ratios.

Furthermore, the long-term information ratio of U.S. BBB companies has historically been even better than that of A rated companies because of the excess premium built in for higher downgrade risk. Based on data back to 1997, the Sharpe ratio (risk-adjusted return) of BBBs has been +0.39 versus +0.17 for A rated companies. Using data back to just 2007, the difference is even greater: a Sharpe ratio for BBBs of +0.70 versus +0.14 for As.

Beware fallen angel risk

In 2016, 18% of low BBB rated companies were downgraded below investment grade and became part of the high yield sector, mainly due to lower commodity prices. (Corporate bonds that have been downgraded from investment grade to speculative grade are known as “fallen angels.”) Based on historical issuance averages and migration statistics, this suggests that close to $80 billion in BBB rated bonds potentially could be downgraded in 2018. In many cases, downgrades and even just negative outlooks from the rating agencies have an outsized effect on spreads.

To avoid the potentially negative impact on returns, it is important for investors to recognize fallen angel risk. Yet, the number of corporate bond issuers has expanded by 33% in the past five years and by 67% in the past 10 years, which suggests that bond selection in investment grade corporates has become more challenging.

Active portfolio managers, unlike passive managers, can invest in bonds outside of the benchmark indexes. And active managers with a deep bench of credit research analysts can aim to cover as many issuers as possible in an effort to select the most attractive bonds and determine which are at risk of falling below investment grade – and correspondingly, which have potential to migrate up from high yield to investment grade (such bonds are known as “rising stars”).

Actively selecting corporate sectors and issuers

As a large active bond manager, PIMCO is in our view ideally positioned to manage the risks in corporate fixed income investing, including in the complicated universe of BBB bonds.

The credit team focuses on companies that are supported by high barriers to entry and pricing power, exhibit above-trend growth and have management teams that act in the best interest of bondholders. Such companies, in our opinion, have a greater ability to reduce leverage in an organic way and retain their investment grade status.

With that in mind, we find many compelling BBB bonds in the U.S. marketplace today. For example, we see value in select healthcare, media, telecom and pipeline companies. However, we are cautious on BBB companies in sectors where credit fundamentals have deteriorated overall and where barriers to entry, asset quality and pricing power tend to be lower, such as retail/grocery, certain niches in technology, consumer noncyclicals and industrials.

Investment implications

We think investors may want to consider taking a more cautious and selective approach to BBB nonfinancial corporate bonds, particularly those in the low BBB rated segment where the risk of downgrades is higher and the room for error is lower. Of note, we are not advocating a generic underweight to BBBs, but rather suggesting a more selective approach in this environment. We still see opportunities in select BBB nonfinancials, especially in sectors with high barriers to entry, above-trend growth and strong pricing power.

Our views on the BBB bond market are part of our overall cyclical view on credit, which has us focused on bottom-up ideas in an environment where generic credit is less attractively priced and potentially vulnerable in the event of a downturn. Read our latest Cyclical Outlook, “Peak Growth,” for more on our macro forecasts and the investment takeaways.

As the room for error in selecting BBB corporate bonds narrows and the size of the low BBB rated segment grows, managing idiosyncratic risk is more important than ever. In that context, we believe active management of corporate bond portfolios, supported by a large, experienced team of credit analysts, can be a highly effective approach.

The Author

Jelle Brons

Portfolio Manager, Global Investment Grade Credit

Lillian Lin

Portfolio Manager, Investment Grade Credit

Related

Viewpoints
Credit, Where Credit Is Due

The implications of an improving macro backdrop and the present late-cycle environment.

Disclosures

London
PIMCO Europe Ltd
11 Baker Street
London W1U 3AH, England
+44 (0) 20 3640 1000

Milan
PIMCO Europe Ltd - Italy
Corso Matteotti 8
20121 Milan, Italy
+39 02 9475 5400

Munich
PIMCO Deutschland GmbH
Seidlstraße 24-24a
80335 Munich, Germany
+49 (0) 89 26209 6000

Zurich
PIMCO (Schweiz) GmbH
Brandschenkestrasse 41
8002 Zurich, Switzerland
Tel: + 41 44 512 49 10


PIMCO Europe Ltd (Company No. 2604517) and PIMCO Europe Ltd - Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. The Italy branch is additionally regulated by the CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) and PIMCO Deutschland GmbH Swedish Branch (SCRO Reg. No. 516410-9190) are  authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The Swedish Branch is additionally supervised by the Swedish Financial Supervisory Authority (Finansinspektionen) in accordance with Chapter 25 Sections 12-14 of the Swedish Securities Markets Act. he services provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2), Brandschenkestrasse 41, 8002 Zurich, Switzerland, Tel: + 41 44 512 49 10. The services and products provided by PIMCO (Schweiz) GmbH are not available to individual investors, who should not rely on this communication but contact their financial adviser.

Data cited herein has been sourced from J.P. Morgan and Morgan Stanley,unless otherwise stated.

Past performance is not a guarantee or a reliable indicator of futureresults.

Investing in the bond market is subject to risks,including market, interest rate, issuer, credit, inflation risk, andliquidity risk. The value of most bonds and bond strategies are impacted bychanges in interest rates. Bonds and bond strategies with longer durationstend to be more sensitive and volatile than those with shorter durations;bond prices generally fall as interest rates rise, and the current lowinterest rate environment increases this risk. Current reductions in bondcounterparty capacity may contribute to decreased market liquidity andincreased price volatility. Bond investments may be worth more or less thanthe original cost when redeemed. Corporate debt securitiesare subject to the risk of the issuer’s inability to meet principal andinterest payments on the obligation and may also be subject to pricevolatility due to factors such as interest rate sensitivity, marketperception of the creditworthiness of the issuer and general marketliquidity. All investments contain risk and may losevalue.

The credit quality of a particular security or group ofsecurities does not ensure the stability or safety of an overall portfolio.The quality ratings of individual issues/issuers are provided to indicatethe credit-worthiness of such issues/issuer and generally range from AAA,Aaa, or AAA (highest) to D, C, or D (lowest) for S&P, Moody’s, andFitch respectively.

There is no guarantee that these investment strategies will work under allmarket conditions or are suitable for all investors and each investorshould evaluate their ability to invest long-term, especially duringperiods of downturn in the market. Investors should consult theirinvestment professional prior to making an investment decision.

This material contains the opinions of the manager and such opinions aresubject to change without notice. This material has been distributed forinformational purposes only and should not be considered as investmentadvice or a recommendation of any particular security, strategy orinvestment product. Information contained herein has been obtained fromsources believed to be reliable, but not guaranteed. No part of thismaterial may be reproduced in any form, or referred to in any otherpublication, without express written permission. PIMCO is a trademark ofAllianz Asset Management of America L.P. in the United States andthroughout the world. ©2018, PIMCO.

XDismiss Next Article
PIMCO