The Danger Lurking in a Safe Corner of the Bond Market

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04/01/2018 | 12:14 pm


By Ben Eisen and Sam Goldfarb



U.S. companies have been bulking up on debt, introducing another wild card into financial markets already rattled by the recent tech selloff and the prospect of rising interest rates.



One slice of the high-grade corporate bond universe is fast becoming the epicenter of these concerns. There is $2.5 trillion in outstanding U.S. debt rated triple-B, according to Morgan Stanley, up from $1.3 trillion five years ago and $686 billion a decade ago. That is the most ever for companies rated triple-B, which is the lowest rung of the ratings ladder for companies that are above more speculative, or junk, bonds.



The fear: If the long economic expansion takes a turn for the worse, investors could jettison the debt of more leveraged borrowers such as triple-B issuers. That would further weigh on companies and potentially exacerbate any contraction.



The International Monetary Fund recently highlighted the triple-B risk in a report on financial stability that warned about "a buildup of financial balance sheet" debt.



"When markets start restricting access to capital in a downturn or a bear market, we tend to find that leverage levels matter a lot," said Adam Richmond, a credit strategist at Morgan Stanley.



Triple-B rated bonds, which now account for 50% of the investment-grade market, have weighed on overall returns for high-quality debt this year. They returned negative 2.2%.



And that wasn't just due to rising short-term interest rates. Notably, bonds above and below triple-B on the ratings ladder did better. Double-A bonds fell 1.8%, while junk-rated single-B bonds were down just 0.6%.



Growing apprehension over debt levels is another sign that investors are retreating from risk and are increasingly questioning whether long bull markets in stocks and bonds are nearing an end. Highflying technology stocks have been crushed in recent days, despite rebounding a bit on the final day of trading last week. More broadly, stocks have swung wildly during the past two months as worries over inflation have emerged for the first time in years.



As the new quarter begins, some money managers are fearing a shakeout.



"There's enough manic news in the marketplace right now to keep investor nerves on edge," said Tom Stringfellow, president and chief investment officer of Frost Investment Advisors, a $3.7 billion advisory firm.



In contrast to junk bonds, those most often associated with leverage, high-grade corporate bonds are considered to be some of the safest debt, often held in the bond portfolios of everyday investors and a cornerstone for big institutional investors like pensions.



Some investors are concerned that the rating scale doesn't fully reflect the risks in a less hospitable market environment. An economic slowdown that hits companies' sales and profits, for example, would spur a rethink of the current ratings breakdown, investors say, potentially leading to many market-roiling downgrades.



"It does appear there may be some overrating, at least compared to history," said Gene Tannuzzo, a bond manager at Columbia Threadneedle Investments, referring to companies having higher ratings than they should. He said he has avoided some recent debt sales due to leverage concerns.



For now, default rates remain low, making elevated debt levels more of medium-term worry for investors than an immediate crisis. Companies have also had an easy time refinancing their debt with interest rates at rock-bottom level, though that could become more difficult and costly in a rising-rate environment. And as long as the economy and corporate earnings continue to grow, debt burdens may be less of a concern.



But there are signs the benign lending environment is eroding. Since Feb. 2, the extra yield that investors demand to own triple-B rated bonds relative to Treasurys has climbed to 1.34 percentage points from 1.08 percentage points, according to Bloomberg Barclays data.



McDonald's Corp. recently sold $500 million of 30-year bonds at a yield of 1.4 percentage points above the comparable Treasury yield. Just before the deal was marketed, the company's existing bonds with the same maturity traded at a 1.29 point spread, according to MarketAxess. That means the company had to make a meaningful concession to investors to get the deal done.



One reason why the amount of triple-B debt is at record levels: Once highly rated companies have bulked up on debt over the years. McDonald's, for example, was rated AA by S&P and Aa2 by Moody's in 2001. Today, the fast- food retailer is rated BBB+ by S&P and Baa1 by Moody's -- a five-notch drop down the ratings ladder as its total debt more than tripled.



The use of cheap debt to finance megamergers is another factor driving up the amount of lower-rated bonds.



Pharmacy chain CVS Health Corp. issued $40 billion of bonds in March to help pay for its acquisition of health insurer Aetna Inc. boosting its debt load. Moody's Investors Service has put CVS's Baa1 rating on review for a downgrade, while S&P Global Ratings has already dropped it to BBB from BBB+.



Other companies in the ratings category that have taken on debt to finance deals include Campbell Soup Co. and General Mills Inc.



Credit-rating firms say that in some circumstances, rising debt levels may be a temporary phenomenon related to M&A activity. But the increased leverage, on balance, makes these companies more vulnerable to future downgrades.



Michael Wursthorn contributed to this article.



Write to Ben Eisen at [email protected] and Sam Goldfarb at [email protected]





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