Falling Yields Are The Risk For Credit

The warning flags are being hoisted. One blog cautions us about a coming blowout in the government and corporate bond markets when rates start to rise. A normally secretive hedge fund, pointing to rock-bottom rates, says it is dumping government and corporate bonds in favour of equities. And a recent Wall Street Journal article tells us that rating agencies are falling behind the curve by not downgrading some heavily indebted investment grade companies.

The message is clear enough: bonds – whether government or corporate – are not the place to be.

Let’s dispense with the obvious. If rates move meaningfully higher then bond prices will fall. And when this cycle finally runs its course and the economy goes into recession, corporate bonds will be hurt.

That said, be careful not to conflate rate risk and credit risk.

 

Rate Risk Equals Opportunity for Corporate Bond Investors

Buy-and-hold investors such as insurance companies, pension funds, and foreign investors dominate the corporate bond market. They buy corporate bonds to match their liabilities and for incremental spread over government bonds. Their goal is to earn interest and be repaid at maturity. Their primary concern, therefore, is default risk. Conventional rate risk comes second.

Indeed, rate risk can be a good thing because corporate bond credit spreads tend to move inversely to rates (Chart 1). That is, spreads tend to tighten when rates are rising and widen when rates are falling. In the years before 2008, yields gradually rose while credit spreads grinded tighter. Since 2012 credit spreads have generally widened when yields were falling and tightened as yields rose.

The simple explanation is that rising rates are often associated with stronger economic outlooks (and lower credit risk), while falling rates reflect economic weakness or uncertainty.

 

Figure 1: Corporate Spreads Move Inversely With Yields

Source: Fred, Macro Hive

 

It’s also worth bearing in mind that there are some who are betting on falling rates. Recent news reports reveal that Eurodollar options positions tied to US rates falling below zero by yearend 2021 are at the highest level since the financial crisis – about 1.2 million contracts. Daily options activity is about 1.8 million contracts.

If those concerns become more widespread, credit spreads could come under widening pressure even as bond prices rally. That’s hardly a development most corporate bond investors would applaud.

 

Fallen Angel Risk Is Out There

The other lurking credit risk is a downgrade from investment grade to high yield. Many investment grade investors either have to divest downgraded bonds or cannot add to existing positions. Assuming the Wall Street Journal article referenced above is correct in suggesting that some companies in the BBB rating cohort have relatively weak metrics, there is significant risk that some of them could be downgraded to junk at some point.

The problem here isn’t default risk per se, at least not in the foreseeable future; it’s more a matter of supply and demand. To put it in perspective, corporate bonds outstanding total about $9.2 trillion – of which about $1.5 trillion is high yield. In recent years the high yield has absorbed well under $100 billion of net new issuance annually.

Meanwhile, The BBB sector has swelled from 38% to 50% of the total investment grade market over the past decade, or about $3.8 trillion. If even 2% of this were downgraded to junk it would overwhelm the current net new supply, probably resulting in significantly wider spreads to absorb it.

At this point we can’t quantify the extent of downgrade risk. But our sense is that if (or when) an economic downturn hits and BBB company metrics weaken further, the at-risk universe is probably significantly higher.

 

Rating Agencies Are Pretty Good At Flagging Defaults

Given the failings of the rating agency process during the financial crisis, it is easy to criticise how they may be approaching the BBB sector today. But in their defence, ratings focus on default risk, not downgrade risk.

The problem was far worse before the dot-com blowout. Back then ratings often remained static until a company was on the brink of default. Since then rating agencies have become much more pro-active, and (whether correctly or not), it is widely assumed that rating agency staff are under some pressure to downgrade a weak company to the CCC cohort at least a year before default occurs. Rating agencies become less pro-active about downgrades higher up the rating spectrum because near term default remains remote. Then it’s up to markets to anticipate problems by pushing spreads wider.

If it’s any source of comfort, the recent performance of the high yield market may bear this out. We noted in a recent MacroHive special that rising triple-C spreads have yet to infect the broader high yield market (Figure 2). So far, problems in the triple-C sector have been due to well-flagged problems in the coal and wireline industries, and those companies have been demoted from the double- and single-B sectors.

 

Figure 2: Triple-C Weakness Hasn’t Affected Broader HY Market

Source: Fred, Macro Hive

Note – the broader HY OAS spread tracks the single-B OAS very closely.

 

Watch the Rates Market!

When the broader high yield market starts leaking wider, that will be the point when the fallen angel problem becomes material. And the probable trigger for both won’t be rating agency actions, but could well be a continued decline in yields and rally in bonds.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)