Corporate bonds

These corporate bonds were supposed to turn into junk. They are thriving instead.

It was a popular narrative in capital markets in 2018. The swarm of corporate bonds with the lowest investment grade was believed to be on the verge of a descent to the high-yield level – the term polite for junk – as soon as the inevitable economic downturn hit. In this case, these former members of the respectable world of investment grade would be punished by a significant decline in the price of their securities and a concomitant increase in their yields.

But that was the case last year. What happened in 2019 was a strong rally in BBB companies, leading to lower returns and strong total returns. Indeed, BBB bonds make up the largest portion of the corporate bond market, accounting for 58.2% of the $4 trillion in investment grade debt outstanding as of September 30, according to a report by Fitch Ratings. That’s actually down slightly from its peak of 58.8% in 2018.

The gloomy predictions of chaos in this sector of the corporate bond market did not come true. According to Strategas Research Partners’ technical strategy team, led by Chris Verrone, the yield spread of Baa-rated companies (Moody’s Investors Service’s equivalent of BBB) over risk-free Treasuries has hit a low of 52 weeks last week, around a third less than the two percentage point peak at the peak of Killer BBB concerns in the summer of 2018.

Spreads are how bond professionals measure the performance and valuation of corporate and other securities. Tighter spreads indicate strong relative prices versus government bonds, since lower yields translate into higher prices for fixed income securities, and vice versa.

High BBB prices prompted record issuance of new BBB bonds, Fitch said. The volume of new investment-grade U.S. non-financial corporate bonds totaled $515 billion in the first three quarters of 2019, a pace that is expected to break the record high of $614 billion for 2017. The BBB portion accounted for 65% of this year’s volume, 11% more than in 2017.

Corporate treasurers and their bankers are opportunistic, bringing new bonds to market when investor demand is strong, and holding back when it is not.

That BBB credits make up more than half of the market for higher quality companies is nothing new. Indeed, it’s the optimal rating for a business borrower, says Cliff Noreen, head of global investment strategy at MassMutual, the big insurance company and a major investor in business credit.

The note provides access to financing at very low cost due to its membership in the universe of higher quality securities, explains Noreen. Upgrading to an A or higher does not translate to significant savings in interest charges, he also notes. And as former junk bond king Mike Milken used to cynically observe, a AAA bond is just a candidate for downgrade.

A BBB rating also provides the financial flexibility to borrow cheaply for acquisitions or to repurchase shares. Topping the list of BBB issuers this year, Fitch notes, were


western oil

(ticker: OXY), who beat


Chevron

(CVX) for Anadarko Petroleum;


Cigna

(CI), which acquired Express Scripts;


Anheuser-Busch InBev

(BUD), which took over SABMiller a few years ago; and


AT&T

(T), which took over Time Warner.

Fitch also found that the BBB minus portion – the absolute lowest notch in the investment grade universe, and therefore the closest to being ejected into the high yield underworld – fell to 14% of the IG universe against 15% in 2018, behind BBB -plus (25%) and BBB (19%). Some bond buyers, such as repos and endowments, have limits on speculative-grade securities, much like mutual funds labeled investment-grade, and may be forced to sell bonds if they are downgraded into territory. undesirable.

The tightening of BBB spreads is indicative of healthy credit conditions in most sectors of the corporate market. In contrast, there has been a widening of spreads on CCC credits, the bottom of the speculative market, which Noreen describes as a healthy development, a proverbial separation of the chaff from the wheat, similar to the downgrading of profitless unicorns. in stock exchange.

“Credit conditions remain broadly supportive of equities, both domestically and internationally,” Strategas analysts wrote in a client note. Not by chance, the


S&P500

reached a record mid-week. At the same time, the


Cboe Volatility Index,

or VIX, which measures volatility for options on the S&P 500, fell to near a 52-week low, also suggesting subdued risk concerns.

That said, Noreen says that for MassMutual’s policyholders, he prefers investment grade and infrastructure debt issued by the private sector, which offers better security and spreads compared to issues offered to the public. Insurance companies have a long history of investing in private placements of corporate debt, which they can tailor to their standards. In public markets, “there are no cheap asset classes to invest in,” he adds.

In 2018, there was near-hysteria about the explosion of BBB bonds. Now there’s a complacency, implied by their tight yield spreads, that little can go wrong. Ironically, greater confidence that the economy will not succumb to recession could mean a reversal for all bond yields, with BBB yields rising and their prices falling, as well as those of risk-free securities.

Write to Randall W. Forsyth at [email protected]