The Bond-Market Panic That Wasn’t

In contrast to previous years, 2019 has resulted in a big rally in BBB corporates, resulting in falling yields and strong total returns

Source: Barron’s

It was a popular narrative in the capital markets in 2018. The swarm of corporate bonds with the lowest investment-grade rating supposedly were on the precipice of a descent into the high-yield level—the polite term for junk—as soon as the inevitable economic slowdown hit. In that event, these erstwhile members of the respectable investment-grade world would be punished with a major decline in their securities prices and a concomitant rise in their yields.

But that was so last year. What’s happened in 2019 has been a big rally in BBB corporates, resulting in falling yields and strong total returns. Indeed, BBB bonds comprise the biggest portion of the corporate bond market, accounting for 58.2% of the $4 trillion of investment-grade debt outstanding as of Sept. 30, according to a report from Fitch Ratings. That’s actually down a touch from its peak of 58.8% in 2018.

The dire forecasts of chaos in this sector of the corporate bond market haven’t been borne out. According to Strategas Research Partners’ technical strategy team, led by Chris Verrone, the yield spread of corporates rated Baa (Moody’s Investors Service’s equivalent of BBB) over risk-free Treasuries hit a 52-week low this past week—about one-third less than the peak of two percentage points at the height of the Killer BBB worries in the summer of 2018.

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

The strong prices for BBBs have resulted in record issuance of new BBB bonds, Fitch says. New U.S. investment-grade nonfinancial corporate bond volume totaled $515 billion through the first three quarters of 2019, a pace set to smash 2017’s full-year record of $614 billion. The BBB portion accounted for 65% of this year’s volume, 11% more than 2017.

Corporate treasurers and their bankers are opportunistic, bringing new bonds to market when demand from investors is strong, and holding back when it isn’t.

That BBB credits comprise over half of the investment-grade corporate market is nothing new. Indeed, it’s the optimal rating for a corporate borrower, contends Cliff Noreen, head of global investment strategy at MassMutual, the big insurance company and a major investor in corporate credit.

The rating provides access to very low-cost financing by virtue of being within the investment-grade universe, Noreen says. An upgrade to single-A or higher doesn’t translate into significant savings in terms of interest costs, he also notes. And as the erstwhile junk-bond king Mike Milken used to observe cynically, a AAA bond is just a downgrade candidate.

A BBB rating also provides the financial flexibility to borrow cheaply for acquisitions or to buy back stock. Leading the list of BBB issuers this year, Fitch notes, have been Occidental Petroleum (ticker: OXY), which beat out Chevron (CVX) for Anadarko Petroleum; Cigna (CI), which acquired Express Scripts; Anheuser-Busch InBev (BUD), which took over SABMiller a couple of years ago; and AT&T (T), which took over Time Warner.

Fitch also found that the BBB-minus portion—the absolute lowest notch of the investment-grade universe, and thus closest to being ejected into the high-yield underworld—shrank to 14% of the IG universe from 15% in 2018, behind BBB-plus (25%) and BBB (19%). Some bond buyers, such as pensions and endowments, have limits on speculative-grade securities, as do mutual funds labeled investment-grade, and may be forced to sell bonds should they be downgraded into junk territory.

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

“Credit conditions largely remain supportive for equities, both domestically and globally,” the Strategas analysts write in a client note. Not coincidentally, the S&P 500 hit a record midweek. At the same time, the Cboe Volatility Index, or VIX, which measures the volatility of 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 policyholders, he prefers privately issued investment-grade and infrastructure debt, which offer better security and spreads compared with publicly offered issues. Insurance companies have long invested in private placements of corporate debt, which they can tailor to their standards. In the public markets, “there are no cheap asset classes to invest in,” he adds.