US investment grade credit: a bubble or a buy?

Is the recent sell-off in BBB-rated bonds a sign of worse things to come, or has the market over-reacted? Are there stabilising trends on the horizon?

Recent market stress surrounding trade policy, the US government shutdown, Brexit and recession fears have increased focus on the US investment grade credit market – and its sharp rise in leverage in the post-crisis period. We believe these concerns are best analyzed through the lens of the BBB rated portion of the US investment grade bond market. Some investors worry that this segment is a ticking time bomb set to upend the US fixed income market. Credit spreads on BBB rated bonds have widened 50-100 basis points in the past year.¹ With a focus on BBBs, we tackle some important questions for investors: Is the recent selloff in BBBs a sign of worse things to come? Or has the market over-reacted and are there stabilizing trends on the horizon?

Upward trend in leverage may reverse in 2019

Debt levels among US corporations have grown in the post-financial crisis period in response to a lack of organic growth, low interest rates, modest credit spreads and tax policy that restricted the use of overseas retained earnings. As such, companies have used incremental debt to 1) buy back stock, 2) fund mergers and acquisitions, and 3) increase shareholder dividends. This shareholder-friendly activity has, however, come at the expense of companies’ credit profiles and has exposed the market to potential credit transition risks, in our view.

Going forward we believe there are several reasons to expect a reversal in this leveraging trend, including a return to organic growth, higher interest rates, wider credit spreads and repatriation of foreign profits. As such, we expect to see less opportunistic funding as acquisition break-even points are higher and companies have increased access to internal capital. Companies are also experiencing increased investor scrutiny over elevated leverage profiles and are beginning to address their balance sheets more proactively. We expect CEOs to highlight their debt reduction efforts and progress in much greater detail during earnings calls going forward. We also note that large companies have begun making deleveraging success one of the many determinants in CEO compensation. We believe these are very positive trends for investors in corporate credit.

Fed has credit growth in its sights

In addition, we believe issuers and investors have taken note of comments from the Fed in its November 2018 Financial Stability Report, which highlighted concerns over the pace of credit growth, leverage and underwriting practices in the leveraged loan market.

The Financial Stability Report also highlighted that the distribution of ratings among investment grade corporate bonds has deteriorated with the number of bonds rated at the lowest investment grade level at a near-record amount. As of the second quarter of 2018, 35 percent of corporate bonds outstanding were at the lowest end of the investment-grade segment, amounting to approximately USD2.25 trillion.² The Fed noted that during an economic downturn, widespread downgrades of these bonds to speculative-grade ratings could force some investors to sell them rapidly, pressuring liquidity and prices in this segment of the corporate bond market.

Ultimately, The Fed noted that, despite elevated leverage, low interest rates have enabled debt service costs to remain at the lower end of their historical range, allowing corporate credit performance to remain favorable. In addition, we estimate that current market spreads cover reasonable estimates of investment grade defaults by multiple times.

IFI US investment grade outlook

We believe risks in BBB rated credit will likely remain idiosyncratic, as most large bond issuers generate substantial free cash flow to service debt. Furthermore, we do not believe a recession is a likely outcome of recent global macro-economic issues, including trade tensions.

We have seen the leverage cycle playbook before with the energy crisis in 2015-2016. Some companies substantially cut their dividends to conserve cash to pay down debt. Others stopped share buy backs and even reduced capital expenditures. In extreme examples they went so far as to raise equity to pay down debt. Once companies began to address their balance sheet concerns, their stock prices began to stabilize and eventually turned higher. We expect this process to play out again with the majority of BBB rated issuers. We think the message to CEOs is clear - the time to start fixing balance sheets is now.

The largest BBB rated companies have the cash flow to support their debt and debt service obligations, in our view, and are beginning to recognize that the market is concerned about leverage. We believe issuers will begin to pay down debt while the economy is still strong. The recent spotlight on BBB’s and punishment of over-levered companies by the equity market is likely to be a major catalyst for balance sheet cleanup. In addition, 2019 earnings growth, which we forecast in the high-single digit range, will likely remain a supportive factor for credit quality. We expect the recognition of this dynamic to result in corporate deleveraging and outperformance of BBB rated credits in 2019.

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¹ Source: Bloomberg Barclays US Credit Index, data from Jan. 24, 2018 to Jan. 24, 2019.

² Source: US Federal Reserve, Financial Stability Report, November 2018.

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