The Blueprint


Fallen Angels:
The Pending Risks in “Safe” Bonds

Aug 2020

Definition:

/Fall•en/ /an•gel/:

A bond that was initially given an investment-grade rating but has since been reduced to junk bond status. The downgrade is caused by a deterioration in the financial condition of the issuer.

The Corporate Bond Market Looks A Lot More Risky

The majority of the bond market is made up of bonds that are “Investment grade”. These Bonds are usually considered to be the safest, holding a rating of BBB to AAA. It is typically thought that the more investment grade bonds a portfolio owns the safer it is. While this has been true historically, the recent deterioration of corporate financials paired with high amounts of corporate borrowing over the past 10 years are bringing this notion into question. For this reason we are asking, are investment grade bonds really as safe as everyone thinks?

One of the core principles of investing is that if you are going to take on more risk, you expect to receive a higher return. Obviously, no one would agree to take on more risk, if they were not being properly compensated. This is certainly the case when it comes to lending your money to a corporation. If you are lending to a BBB rated company (risky but still “investment grade”) versus an AA rated company (solidly “investment grade”), then you would expect to receive a higher yield in order to compensate for the heightened risk. The difference between the yield of these BBB and AA rated bonds is known as the spread. As of July 2020, AA rated corporate bonds are yielding in the 1.42%1 range, while BBB corporate bonds are yielding in the 2.46%2 range. This means the spread between AA and BBB rated corporate bonds was a small 1.04%. Investors are desperate for yield in such a low rate world that they are willing to take on more risk to get it. The question is, do these investors know how much additional risk they are really taking on? With this risk premium (reward for increased risk) very low, it is important to look at the remarkably high concentration of BBB rated bonds as a percentage of the overall corporate bond market to properly understand the risks being taken when investing in bonds of lower credit quality.

Amount of Corporate Debt by Rating

Source: S&P Global, 05/17/2019

As you can see in the graph above, over 40% of the bond market is rated BBB.3 This means that a large majority of the bond market stands one step away from being labeled as “Junk.”

Lines in the Sand

There are questions as to whether many of these BBB bonds even deserve to be rated as investment grade. Looking into the debt ratios (debt to earnings) of these bonds, they are historically not in line with an investment grade rating. Since 2007 the debt ratios for each bond rating have risen, shifting the line between investment grade and junk bonds. The typical debt ratio of a BBB bond today would be the debt ratio of a “junk” bond in 2007 as can be seen in the chart below.

Debt Ratio by Bond Rating Over 10 Years

 Source: S&P Capital IQ, TDAM, 06/2018

Cheap Borrowing Has High Costs in Hard Economic Times

Some say the reasoning for this leniency in bond ratings has come from companies asking ratings agencies to not downgrade their bonds ahead of taking on large debt. Companies would say that the debt was being used to acquire companies and therefore should be viewed differently, and the rating agencies have largely allowed this.4 With interest rates at all time lows over the past 10 years, this type of activity has been pervasive. Despite what corporations may say, this increase in debt does represent increased risk. This is especially realized in the wake of COVID-19 where slowdowns in revenues of portfolio companies might inhibit the ability of these companies to service debt.

Fallen Angels Face A Potential Sell-Off

Whether rating agencies are becoming complacent or less stringent, they are evidently starting to downgrade. During 2020, Kraft, Ford, Delta and Macy’s were downgraded to junk status. Lower rated bonds can run into trouble during economic downturns when there tends to be a significant increase in rating downgrades. The largest challenge that occurs when a bond is downgraded from investment grade to junk status is termed “forced selling.” There are many Investment Firms, Banks, Institutions and Insurance Companies, for instance, that have policies that do not allow them to own bonds rated below investment grade. This can cause significant repricing of the bond market potentially causing losses these bond holders.

About Blue Square

As the saying goes, “smart investors are greedy when others are fearful, and fearful when others are greedy.” As a result of a multi-decade bull market in bonds, many investors have gotten comfortable with the risk/return characteristics — but have not put much consideration into what the risks would look like should economic conditions continue to deteriorate.

At Blue Square, rather than trying to predict the future we aim to prepare for it. We do not know if and when these risks will materialize, however we use our proprietary technology and rules-based investing approach to be prepared should they present themselves.

Our investment strategy aims to position portfolios defensively during significant market declines. By systematically raising cash during these periods and then investing it when markets are more accommodating, we aim to create a less volatile investment experience, and ultimately deliver better risk-adjusted returns over full market cycles.


1) Source: YCharts, US Corporate AA Effective Yield, 07/20/2020
2) Source: YCharts, US Corporate BBB Effective Yield, 07/20/2020
3) Source: S&P Global, 05/17/2019
4) Source: TD Asset Management

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