Jack Willis

Fallen angel risk – not all BBB bonds are created equal

Jack Willis

Hedge fund manager Steve Eisman became a household name in certain circles for betting against the US housing market before the 2008 crash as depicted in The Big Short – so his recent warnings about corporate bonds should not be taken lightly. Eisman has expressed concerns about the rapidly expanding BBB bond market (the lowest credit rating still considered investment grade), citing potential liquidity risks in the event of a global slowdown.

 

At the end of December 2018, the BBB segment made up over 55% of sterling investment grade credit and is just shy of 50% in the euro and US IG markets: growth is accelerating at its quickest pace since the financial crisis. This is understandably driving speculation on whether this is a bubble ripe for bursting and given the sheer size of the market, quadrupling since the 2000s to over $2.5 trillion globally, we are also seeing concerns about fallen angel risk, where BBB issuers are downgraded to high yield.

While there are areas where we would advise caution, it is important to remember not all BBBs are created equal. We had 52.3% BBB exposure in our Monthly Income Bond Fund and 62.8% in our SF Corporate Bond Fund at the end of 2018 and remain confident an active approach to stock selection can avoid the higher-risk parts of this market.

At the most basic level, there are three notches within BBB – BBB+, BBB and BBB- – so statements that it is the ‘riskiest’ investment grade segment are alarmist without considering the magnitude of debt in the BBB+ and BBB buckets: in terms of credit quality, these are arguably a lot closer to single A than high yield.

Looking historically, large-scale rating migrations have been linked to the macroeconomic environment, with downgrades clearly prevalent in global downturns and recessions. Our belief is that the macro backdrop remains positive, supported by solid economic growth, low default rates, loose monetary policy and robust trends in corporate earnings. In the absence of a widespread downturn, we see risk within the BBB space as largely sector and stock-specific.

While we remain broadly positive on the macro side however, global growth is undoubtedly slowing and, in that environment, cyclically exposed sectors and companies present the highest fallen angel risk. For us, the most affected areas are autos and retail. Autos have come under increasing pressure from falling demand, US-China trade wars and tightening monetary policy, resulting in a challenging outlook for the sector and particularly companies with weaker credit profiles. The outlook for retailers is similarly challenging, with falling high street footfall, weak consumer confidence, a structural shift towards online retailing and rising cost pressures.

In contrast to sectors facing such challenges, a large part of the BBB exposure in our funds is through telecommunications and utilities, non-cyclical areas that will perform better operationally through slumps in the business cycle. Issuers in these sectors tend to sit in the BBB+ and BBB buckets, reflecting their more defensive nature.

Taking the broader BBB sector, when analysing bonds, we believe it is not a company’s rating per se that is the core issue but rather its capacity to service the debt load. In order to assess this, we consider a company’s cashflow generation ability (before dividends and shareholder payouts) versus total interest charged, alongside leverage metrics such as net debt/EBITDA, debt less cash/earnings and so on.

Based on these measures, we believe balance sheet quality remains relatively strong among BBB issuers in general, increasing their ability to withstand a downturn. A key driver has been that companies have been able to borrow at considerably lower rates than a decade ago: that was ultimately the goal of quantitative easing, to push down rates in order to allow companies to borrow and invest.

Balance sheet robustness also reflects the more prudent nature of management among BBB-rated issuers, who tend to be more conservative as they are conscious of the consequences of falling into the high yield universe, particularly the impact on future access to capital. This is further emphasised by the fact growth of BBB issuers comes from companies downgraded from single A: these businesses have taken a more aggressive approach to balance sheet management and seen deteriorating fundamentals as a result.

In 2018, arguably the most notable downgrade from the single A tier was General Electric (GE), where increasing leverage and negative earnings growth saw it drop to BBB, having been AA rated as recently as 2015. Unlike GE however, the shift from A to BBB for a number of European and UK companies has been a deliberate move. The additional financial flexibility of running BBB balance sheets is arguably more economically efficient for many of the sectors that make up these market (utilities, retail and so on), especially in such a low-yield environment.

Overall then, we remain comfortable to hold BBB-rated bonds despite the burgeoning size of the market. As stated, we believe risks remain largely sector and stock specific and an active approach can avoid these areas. A large part of our BBB exposure remains in non-cyclical sectors such as telecommunications and utilities, where we see greater protection in the event of any economic downturn.

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Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. The majority of the Liontrust Sustainable Future Funds have holdings which are denominated in currencies other than Sterling and may be affected by movements in exchange rates. Some of these funds invest in emerging markets which may involve a higher element of risk due to less well regulated markets and political and economic instability. Consequently the value of an investment may rise or fall in line with the exchange rates. Liontrust UK Ethical Fund, Liontrust SF European Growth Fund and Liontrust SF UK Growth Fund invest geographically in a narrow range and has a concentrated portfolio of securities, there is an increased risk of volatility which may result in frequent rises and falls in the Fund’s share price. Liontrust SF Managed Fund, Liontrust SF Corporate Bond Fund, Liontrust SF Cautious Managed Fund, Liontrust SF Defensive Managed Fund and Liontrust Monthly Income Bond Fund invest in bonds and other fixed-interest securities - fluctuations in interest rates are likely to affect the value of these financial instruments. If long-term interest rates rise, the value of your shares is likely to fall. If you need to access your money quickly it is possible that, in difficult market conditions, it could be hard to sell holdings in corporate bond funds. This is because there is low trading activity in the markets for many of the bonds held by these funds. Mentioned above five funds can also invest in derivatives. Derivatives are used to protect against currencies, credit and interests rates move or for investment purposes. There is a risk that losses could be made on derivative positions or that the counterparties could fail to complete on transactions.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.
Tuesday, February 12, 2019, 10:48 AM