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Blog Posts — April 28, 2020

Is BB the new BBB?

by Christoph Schon, CFA, CIPM

The recent decision by the Federal Reserve Bank to add high-yield funds to its asset-purchasing program triggered unprecedented flows into exchange-traded funds specializing in sub-investment grade securities. At the same time, newly issued debt from recently downgraded issuers was greeted by record demand. Does this mean that investors are betting on a swift recovery and see the current environment as a buying opportunity? Or are they just adapting to a new reality? Is BB becoming the new BBB?

Falling angels…

In one of our recent blog posts, we noted an increased risk of fallen angels—issuers downgraded from investment grade to high yield. According to the Financial Times, the US corporate-bond market experienced a record $90bn fall to ‘junk’ status in March. Including the latest figures for April, the year-to-date number rises to over $120bn, and analysts predict that the total for 2020 could top $200bn. This can be expected to put a lot of pressure on the high-yield segment, which totals just over $1.1tn, as measured by the full market value of the ICE BofA US High Yield Index. So, why is new debt in that market meeting such healthy demand?

…caught by a safety net

One explanation could be a recent move by the US central bank. The Federal Reserve announced on April 9 that it would include lower-rated debt in its latest asset-purchasing program. Although the bank will not purchase high-yield bonds directly, it will acquire shares in exchange-traded funds that track that segment of the market. The announcement was followed by inflows of more than $10bn into funds specializing in high-yield debt. The Fed will also buy bonds that had an investment-grade rating on March 22, but were subsequently downgraded. The move was then mimicked by the European Central Bank, which will accept sub-investment grade debt as collateral in its funding facilities, as long as the securities were rated at least BBB- as of April 7.

The lines are blurring…

The fact that major central banks are starting to accept sub-investment grade debt could be yet another indication that the distinction between investment grade and high yield is beginning to fade. As we noted in our whitepaper on High-Yield Bonds, the risk and return of a typical investment-grade bond portfolio would be mostly driven by changes in risk-free interest rates, while the prevailing force in high yield would be the dynamics of credit spreads. This was still the case even in early March, when share prices had already been falling sharply for more than two weeks. However, once US Treasury yields bottomed out and then bounced up in the scramble for cash after March 9, the double-blow of rising rates and spreads meant corporate-bond returns were suddenly driven by credit spreads across the entire rating spectrum.

The graph below shows the predicted volatility of USD-denominated corporate bonds with an average duration of seven years, calibrated on weekly factor changes over a lookback period of five years, with a half-life of one year. As of March 6, the total risk of the two investment-grade categories—single-A and triple-B—consisted almost exclusively of interest-rate volatility, with a bit of diversification from the credit component. It is also worth noting that the overall variations of the single-A and triple-B were essentially the same, indicating that investors saw them as almost identical in terms of riskiness. There was a clear distinction, though, toward double-B, which was not only more volatile, but also entirely dominated by the credit component.

Predicted volatility for USD corporate bonds

Source: Axioma Risk

After reaching their lowest level on record on March 9, US Treasury yields have mostly moved sideways, while credit risk premia soared at their fastest pace since the Lehman Brothers default in autumn 2008. This decoupling of the two major drivers of fixed-income returns meant that credit spreads became the predominant source of corporate-bond risk, irrespective of the issuer’s creditworthiness.

…but the distinctions remain

That said, the increase in predicted volatility for BB-rated securities was much greater than for BBB. When comparing the latter with its neighboring categories, the behavior seemed more in line with the single-A bucket. This also applies to the makeup of the contributions to overall risk, in particular when looking at the most recent numbers for April 17. We saw the same pattern emerge in a series of transitive stress tests in Axioma Risk. The chart below shows simulated returns of USD corporate bonds for a 10% drop in US share prices, based on factor betas and correlations calibrated over the three months preceding each analysis date. The results in every rating bucket were once again normalized to a 7-year duration.

Simulated returns for a 10% drop in US share prices

Source: Axioma Risk

When looking at the first period, we once again see the clear demarcation line between investment-grade and high-yield debt, with the latter experiencing negative returns from rising risk premia, while the former still benefitted from lower risk-free rates. Once sovereign yields decoupled from share prices and credit spreads, the strong relationship between the latter two prevailed and losses occurred across all rating bands. More recently, though, some of the old interrelationships seem to be reemerging, with better-quality issues once more exhibiting positive returns.

What once was BBB may become BBB again

The observation that the recent behavior of BBB securities seems to have more in common with better-quality issues than with lower-rated debt, indicates that the traditional border between investment grade and high yield is still largely intact—despite the fact that credit spreads have (temporarily) become the dominant driver of corporate-bond risk and returns.

So, to answer the original question of whether BB will become the new BBB, let’s say that investors appear to be betting on the fact that some issuers, who were recently downgraded to double-B, may soon regain their coveted investment-grade rating.