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CIP Quips

BBB’s: Quantity vs. Quality

In the news:

A common misconception of the BBB rated investment grade bond universe today is that quantity affects quality.  While the U.S. corporate bond investment grade universe has indeed experienced a significant increase in both the size and market share of BBB rated securities (as compared to “A” rated securities), this does not necessarily imply a decrease in quality.  According to Barclays, - “Given the increasing size of the BBB cohort (in both absolute and relative terms), investors have raised concerns about the potential effect that fallen angels (a once investment grade rated bond that has since been downgraded to high yield) could have”… “For the broader BBB category, though, credit fundamentals have remained stable or improved slightly in recent years. Specifically, leverage for BBB’s at 2.8x at the end of 1Q 2018, was down from 3.4x and 3.0x at the end of 2015 and 2016, respectively.”

Barclay’s also points out that the BBB credit segment has grown to about 50% of the U.S. Investment Grade Credit Index, up from 37% at the end of 2010.  However, digging a bit deeper we find that the increase in the BBB’s, as a percentage of the overall investment grade market, has been in consumer non-cyclical and defensive industries which can withstand an economic downturn far better than cyclically-levered names.  It is also interesting to note that the lower end of the BBB segment (credits rated BBB-) has actually stayed the same, in percentage terms, of the overall investment grade index, implying no increase in the risk of securities “dropping” to high yield.  In fact, Fitch Ratings Agency expects that 2019 will have the lowest corporate default rates on bonds since 2013.

What we are thinking:

Corporate profit growth is bound to slow eventually but remains near record highs.  The corporate tax rate reduction also leaves companies with higher profitability after taxes to work with (net income, retained earnings etc.) which boosts an issuer’s ability to pay back debt. Investment grade and high yield issuance should decline in the coming years as the corporate tax rate gets reduced and leverage declines, allowing for improved credit quality in bonds purchased. 

The size of the BBB market does not matter for an individual investor, but the credit quality of the issuer does.  The size of the BBB market relative to the investment grade universe should not be a concern unless those companies that make up the BBB segment actually face credit concerns.  At Roosevelt Investments our investment process starts by evaluating current credit market conditions to determine optimal construction.  This includes identifying sources of risk, setting effective risk limits, yield curve positioning, sector allocation, diversification and duration management.  Yield and spread analysis is an important part of our credit analysis. CIP is an attractive solution for income investors who are looking for conservative allocations and additional yield an either a low rate or rising rate environment. Temporary market distortions and pricing inefficiencies will provide opportunities to improve overall portfolio yield and income characteristics.  Let us show you how!

Source: Barclays U.S. Credit Research June 29th 2018

 


 

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