October 23, 2017
The statement seemed innocuous: “BBBs rule investment grade bonds”. But that simple statement summarizes an important story about the current state of the credit market. Before explaining why let’s first do a quick refresher on the fascinating world of bonds.
As you know, bonds are a form of IOU which governments, municipalities, and large companies use as a means of finance. Bonds are “rated” based on the ability of the issuer to pay back the debt, with a range of ratings from AAA (the best) to D (in default). The highest ratings, from AAA to BBB-, are known as investment grade. Bonds rated below BBB- are commonly referred to as speculative or junk. Only two companies in the US are currently rated as AAA, Johnson and Johnson and Microsoft. Even US government debt has fallen to the second tier AA+ .
There are three main credit rating agencies for bonds: Moody’s, Standard and Poor’s, and Fitch. Each of these rating agencies views BBB bonds as having a low likelihood of default, but with some credit risk if there is an adverse change in circumstances affecting the issuer. Such changes could include more difficult economic circumstances. In other words if you buy BBB bonds you also take on some risk and certainly more risk than in the higher tiers of the investment grade category.
So why does this matter? The answer was in a recent WSJ article which reported that BBB rated bonds now represents 50% of all investment grade debt, an increase from 20% just 11 years ago. The fall in the average quality of investment grade bonds has been unusual. There are likely several explanations but one answer lies in investors’ desire for more yield.
Years of low rates have forced investors to “reach for more yield”. For example, if a AAA bond is yielding 2.5% but an investor opts instead for a 3% on a BBB bond, then they are reaching for more yield. In effect the investor’s wish to increase their return means they are less discerning about the higher risk associated with that return than they would be in more normal market conditions.
This reaching for higher yields has provided a cheap form of finance for companies with some credit risk, for example the BBB bond index has recently yielded 2.89% as compared to the 20 year average of 5.1%. Moreover the differences in yield between higher quality and lower quality bonds has been heavily compressed to levels never seen before. In 2008 the difference in yield between AAA and BBB bonds was 4.0 %. Today that difference is 0.25%.
We debate regularly the risks investors are taking in the stock market but the data above suggests that investors have taken on more and more risk in bonds as their search for return continues. Remember one of our core investment rules is that you should be rewarded for taking on higher risks by commensurately higher returns. That does not seem to be the case in the bond market today.