Is there a triple-B bond bubble?

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      By John H. Croft, CFA, Investment Grade Fixed Income Portfolio Manager/Team Leader, Eaton Vance Management and Stacey Starner McAllister, Director of Investment Grade Fixed Income Research, Eaton Vance Management

      Boston - For years, investors have been reading headlines that U.S. corporate bonds are in a bubble. Recently, the negative attention has been on BBB-rated bonds, or the lowest rung of investment grade.

      Although the BBB segment is far larger than was just a decade ago, we think claims that risk is dramatically increasing in this market segment are overblown. Specifically, we don't think eventual quantitative tightening (QT) by central banks or an economic slowdown will cause a wave of "fallen angels," or BBB-rated companies being downgraded to non-investment-grade or high-yield.

      Credit fears went too far

      Perhaps some of the anxiety is driven by the credit jitters in late 2018 that hit corporate bonds, investment-grade and high-yield alike. Company-specific issues like those facing GE and PG&E may have also caused investors to paint all corporate bonds with the same brush.

      However, credit spreads have narrowed since then, and BBB bonds have performed well, suggesting markets were too pessimistic about the economy, and that the yields are attractive. The Federal Reserve signaling a more patient stance on rate hikes and balance sheet normalization has also provided a tailwind. Finally, ratings agencies Moody's and Fitch both released reports earlier this year saying they thought worries of BBB downgrades to create fallen angels were overdone.

      BBB market is bigger

      The size of the BBB market rose to about $3.1 trillion in 2018 from about $756 billion in 2007, based on the growth of the ICE BofAML Indices. The share of BBB-rated bonds within the overall investment-grade space has been steadily rising since 2009. At least some of this growth has been driven by companies taking on debt to buy back shares, which has been applauded by investors. Some companies have taken advantage of low rates and strong investor demand to borrow.

      The vast majority of growth in the BBB corporate bond universe was driven primarily by new issuers (53%) and downgrades from the "A-AAA" tier (32%).

      We are generally not too concerned about the downgrades into the BBB bucket. A lot of this has been caused by a change in rating criteria relating to financials by the rating agencies post crisis. We would note that, counterintuitively, credit strength for these downgraded financials has actually been significantly improving since 2007.

      Not all BBBs are the same

      Notwithstanding our generally benign view of BBB rated bonds, there are certainly some pockets of elevated risk. We have some concerns about some commodity-sensitive businesses where there is higher leverage and a large amount of debt.

      Even within the energy sector, there is some significant differentiation between subsectors and business models. On one hand, pipelines and liquefied natural gas (LNG) processers typically have far less cyclical revenue because they are not somewhat insulated from volatile commodity prices - they are just moving products around, not selling it - and therefore can support more debt without a problem.

      On the other hand, exploration and production is a different matter because these companies have direct exposure to commodity prices and a high level of required investment.

      Bottom line: We think the broad concerns about risk in the triple-B market are overblown. That said, there are pockets of risk and we believe active management and a professional research team can help investors navigate the corporate-bond market.