A version of this article was published in the September 2018 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting the website.
In March, my colleague Emory Zink wrote about elevated risks of a sell-off in the corporate bond market ("Tiptoeing Towards the Exits in Corporates"). Citing remarkably narrow option-adjusted spreads among investment-grade corporate bonds (85 basis points in January--a decade low), she discussed some intermediate-term bond funds that had begun to pare back their corporate exposures.
As of September 2018, investment-grade corporate bonds continued to look rich despite some widening (investment-grade credit spreads sat at 113 basis points at the beginning of the month). Over the past year, bearish investors have cited the increasing share of BBB bonds in investment-grade corporate indexes as reason for concern. Because these bonds straddle the investment-grade/high-yield divide, they are considered the least secure within the investment-grade spectrum, and thus more at risk of downgrade. The share of BBB debt in the Bloomberg Barclays Corporate Bond Index grew to 48% in July from 33% a decade ago, suggesting that the quality of the overall investment-grade corporate market is on the decline.
But the growth of BBB rated bonds in the index presents a mixed picture. Some managers point out that there remain healthy slivers of that market. In August, Neuberger Berman noted that many of the newest entrants to the BBB bucket were financials, as ratings agencies adopted tougher criteria for banks after the financial crisis, despite positive trends in the quality of these companies' balance sheets. Excluding financials, the proliferation of BBB corporate bonds augurs a less-benign outlook. Low interest rates and tax reform stimulus have encouraged debt-financed mergers in sectors that historically haven’t engendered much of that activity. J.P. Morgan pointed to telecoms as a sector in which merger and acquisition enthusiasm has encouraged increased leverage in these typically defensive companies.
From January through August 2018, the Bloomberg Barclays US Corporate Bond index lost 2%--double the 1% loss of the Bloomberg Barclays US Aggregate Bond Index. That weakness led some funds to add to their BBB exposures. The median exposure to BBB bonds in the intermediate-term bond Morningstar Category was 18% as of September.
Rob Galusza and Dave DeBiase at
A few managers with perennially large BBB exposures took haircuts. Gold-rated