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Investment grade (IG) corporate bonds have become increasingly popular among yield-seeking investors. While passive index funds provide low cost access to IG markets, active research-driven strategies are vital if investors are to be compensated for the risks they are taking in today’s market environment.
A perfect storm
Suffice to say that on New Year’s Eve 2019, as people around the globe celebrated the beginning of a new year with optimism and enthusiasm, no one could have imagined the perfect storm of unprecedented events that would soon unravel—bringing the global economy and markets to their knees.
The beginning of 2020 quickly became riddled with panic as the global Covid-19 pandemic took its course. As investors fled to cash, no asset market was spared. Within the fixed income market, liquidity effectively all but evaporated, US crude prices fell below zero for the first time in history, and corporate bond spreads reached their widest levels since the global financial crisis of 2008-2009.
While this current crisis has started to abate and vaccine rollouts have ramped up globally, the lessons learned throughout the market turmoil of the first quarter of 2020 will not soon be forgotten, particularly for investors in IG corporate bonds.
The attraction of investment grade credit
IG corporates (meaning those rated BBB- and above) have historically been touted as a high quality safe haven for investors seeking a steady stream of income and yield, but with limited appetite for default risk.
After the global financial crisis, historically low interest rates and the never ending search for yield made IG corporate bonds an increasingly popular asset class. Due to the underlying credit risk, these bonds offer a spread premium above government bonds—and as a result, a higher yield—fuelling demand particularly for non-US investors facing negative local rates in Asia and Europe.
This continuous increase in demand, accompanied by seemingly lenient rating agencies, has enabled IG issuers to enjoy nearly uninhibited and low cost access to debt markets, with the amount of IG debt outstanding growing nearly two-fold since 2009. However, as the market has grown, there has been a deterioration in overall credit quality and an increase in dispersion of the underlying creditworthiness of individual issuers.
As a result, the composition, investment characteristics and potential benefits of an IG allocation will be shaped to an even greater extent by the approach used to gain that exposure.
Cheap and easy isn’t always best
Over the years, there has been a significant rise in passive indexing strategies that are designed to closely track an index while minimising costs, and which basically take portfolio composition as a given. Until early 2020, choosing a passive approach had appeared to be a cheap and easy solution to access the investment grade corporate market.
However, what seems to have eluded investors is that the passive investment style is exposed to an inherent weakness of the IG corporate bond index — its debt-weighted design, which gives the greatest weight to issuers with the greatest amount of debt. The objective to minimise tracking error forces investors to hold higher concentrations in these most indebted issuers without any consideration for the difference in the underlying creditworthiness — and as a result credit risk — of the corporations they are lending to.
In contrast, active, research-driven strategies — that is, those using fundamental, relative value and technical inputs in security selection — seek to identify the most attractive IG holdings from a risk-adjusted return perspective. What’s more, active credit strategies have the flexibility to respond to shifts in an index’s composition, by focusing on selecting securities that compensate investors for the amount of risk they are taking.
Don’t run out of fuel
As many investors experienced in 2020, it is critical to understand the fundamental risk of individual companies and to ensure investors are being appropriately compensated for that risk.
Given the amount of growth in corporate debt and leverage, IG bonds have become more susceptible to downgrade risk, with nearly 50% of the market comprised of lower quality BBB-rated issuers. In a strong economic environment, like we have seen over the last decade, these companies are able to hold higher levels of debt at very little cost. This situation can continue as long as revenues and growth are maintained. However, when the fuel tank runs out, there will be a price to pay for this risk. And that is exactly what we saw last year.
Take the Ford Motor Company, for example, which was downgraded to high yield at the end of March 2020. As the market started to price in this downgrade, the credit spread — or risk premium — on Ford’s bonds widened over 600 basis points, and the price of these bonds fell from €104.33 to €81.89 (over 20%) in just one month.
Source: J.P. Morgan Asset Management, Bloomberg Barclays Indices. Index = Bloomberg Barclays Euro Aggregate Corporate Index. Data as of 31 March 2020.
With around $14 billion of euro-denominated debt outstanding at the time, Ford was a relatively large component of the European IG Corporate Index. Due to the nature of passive indexing, investors using a passive approach to gain exposure to IG credit would have been forced owners of these bonds, and consequently forced sellers when the index rebalanced at month end.
Avoid the fallen angels
While corporate balance sheets have had a strong recovery over the last year as economies and revenues have come back online, we mustn’t forget the speed at which the market unravelled and the impact this had on credit ratings and corporate bond spreads. In the first half of 2020, nearly $200 billion of investment grade corporate debt had been downgraded to junk status. These “fallen angels” accounted for over 1.5% of the Global Investment Grade Index and over 2% of the US Investment Grade Index.
As long-term investors, it is important to reflect on what happened during the pandemic-driven market crisis and not get complacent. Because regardless of where we are in the credit cycle, distinguishing between the good credits and the bad, using an active, research-driven approach, could make all the difference.
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