The fixed income market is starting to look a little bleaker. U.S. corporate debt is at a record high as many corporations took advantage of low interest rates to fund a record number of mergers and acquisitions last year. But analysts say we’re near the end of the credit cycle, and credit quality is diminishing.
In fact, half of the Bloomberg Barclays investment-grade bond index comprises BBB-rated bonds, one step away from high yield; that’s nearly double the level of the 1990s. The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), based on the Markit iBoxx USD Liquid Investment Grade Index, with 48 percent of its bond portfolio at a BBB rating, saw one-year outflows of nearly $7 billion, according to Morningstar data ending November 2018.
As the economy and markets slow, some analysts say we could see a wave of so-called “fallen angels,” bonds originally issued at investment grade but downgraded to junk. (To be sure, there are a few ETFs that exist to catch the angels on their way down.)
The concern among some is that the ETF managers of widely held, investment grade corporate debt funds will be forced to sell the junk bonds, and the price of the fund will fall.
According to Moody’s, the number of potential fallen angels, Baa3-rated companies with either a negative outlook or that are on review for downgrade, increased to 47 at the end of the third quarter last year, compared with 42 in the second quarter. (Baa3 is the lowest investment grade rating on the Moody’s scale.) In addition, the debt of potential fallen angels in the U.S. rose to $102 billion in the third quarter, the highest it’s been since Moody’s first started collecting that data in 2014.
“The border between investment grade and high yield has been recognized in the marketplace as a weak spot for passive managers, because they're really obliged to sell something that's had a downgrade,” says Elisabeth Kashner, vice president and director of ETF research at FactSet. “In any market when you've got a whole bunch of forced sellers, what's going to happen to the price?”
Five of the biggest ETFs that could be affected by a downgrade of BBB-rated bonds, according to ETFTrends.com, include LQD, the Vanguard Short-Term Corporate Bond ETF (VCSH), the Vanguard Intermediate-Term Corporate Bond ETF (VCIT), the iShares Short-Term Corporate Bond ETF (IGSB) and iShares Intermediate-Term Corporate Bond ETF (IGIB).
An Overblown Fear
But ETF watchers say the fear of fallen angels on corporate bond ETFs is misplaced. Asset managers have been through periods of heightened downgrades before, with fairly minimal impact on most investors.
Despite the perception of an indexed bond fund being rules-based and relatively static, taking bonds in and out of a portfolio is par for the course for many managers who have leeway to deal with downgrades without the forced sale of bonds at a depressed price.
“If you are a fixed income portfolio manager, just on a routine, run-rate basis, you expect adjustments to the index, which you are obliged to track; you expect those adjustments pretty much on a monthly basis,” Kashner says.
“There is a narrative out there that, if a downgrade happens, the index manager must sell that bond on the very last day of the month, robotically without consideration for execution … because the last day of the month is rebalancing,” says Steve Laipply, head of U.S. iShares fixed income strategy at BlackRock. “That is not, strictly speaking, true.”
Asset managers don’t have to wait until the end of the month to rebalance, Laipply says. “Part of the role of the portfolio manager is to understand market conditions and to make a decision on what would be the most optimal time to sell.”
“Particularly within fixed income, investing is never passive,” says Matthew Bartolini, head of SPDR Americas Research at State Street Global Advisors. “An index manager will make relative value active decisions. But those active decisions are not to seek alpha. Rather, it is to minimize beta degradation due to high trading costs.”
SPDR may look to trade a bond on a day of the month when that issue is more liquid, as the price can change when trading is thinner, Bartolini says.
“If there's a significant amount of downgrades, we're going to be using those really flexible techniques that we have as index managers, such as optimization or sampling, to make sure that the portfolios will have the necessary data exposure to track their index and mitigate any sort of high transaction costs.”
Bond Funds Are Different
“It’s easy for investors to think, ‘These are passive; these are indexed; they’ve got to just do whatever happens to the index,’” says Todd Rosenbluth, director of ETF and mutual fund research at CFRA. “It’s not as clear as that.”
While equity ETF managers will fully replicate an index, bond managers buy just a sample of the market to replicate the underlying risk factors of the index, such as the duration exposure, credit spreads, and sector and industry exposures. That gives the manager leeway to build samples that will have the least amount of downgrades, says Josh Barrickman, head of fixed income indexing Americas at Vanguard.
“We do have a team of senior analysts that will opine on different credits, give us some sort of their take on the direction of a lot of different credits, and we can factor that into how we build the samples in our portfolios.”
VCIT, for example, has about 1,900 securities, while the index, the Bloomberg Barclays U.S. 5-10 Year Corporate Bond Index, has close to 2,000 securities in it. A number of the securities in the index but not the ETF are either illiquid or too expensive to transact in.
If an analyst expects a bond to be downgraded in the next three to six months, good managers may start to build in an underweight to that name ahead of a downgrade, or simply won’t add to that name.
“We are going to use our technique that we've honed over the last 30 years as index managers to precisely deliver that beta exposure to clients they've hired us for,” SPDR’s Bartolini says. “If that means holding less bonds in the index because those smaller bonds may not be additive to the portfolio but they'll be destructive from a cost perspective, the cost to purchase those outweighs the beta afforded by them.”
ETFs Have Weathered Downgrades Before
There is historical precedent for this pace of downgrades. In 2002, 17.7 percent of BBB bonds were downgraded; it was 13.6 percent in 2009, according to a Moody’s study. Managers also experienced a heightened volume of fallen angels in 2015 when energy prices collapsed. (There were just 14 actual fallen angels in the first three quarters of 2018, Moody’s says, similar to the 12 for the full-year 2017 and much lower than the 63 in 2016. Moody’s attributes that high volume in 2016 to weakness in commodity-linked industries and the downgrade of Brazil.)
“[In 2015 and 2016], I think the performance of the investment grade ETF actually was fairly good,” said Francis Rodilosso, head of fixed income ETF portfolio management at Van Eck, which runs the Fallen Angel High Yield Bond ETF (ANGL). “I think they continued to track their indexes fairly well, and there were some pretty large issuers in those spaces that moved down to high yield.”
Rodilosso says the recent volumes of fallen angels are not significantly higher than in the past. He says the BBB universe is currently over $800 billion, and about one-eighth of that, a little over $100 billion, is on negative watch by the ratings agencies.
But there is potential for higher downgrade volume in the next 12 months, and it can be a technical buying opportunity, he says. Historically, bonds in the ICE BofAML US Fallen Angel High Yield Index—which buys original investment grade bonds that have fallen to junk status—see an 8 percent price decline in the six months prior to index entry and almost a full recovery in the six months after. “But the dispersion of actual results around that average is quite high.”
“From a day-to-day risk management perspective, there’s virtually no difference in terms of the actual cumulative probability of default between a bond that’s at the bottom of investment grade and that’s at the top of junk,” says Dave Nadig, managing director of research firm ETF.com. “This is where discussions about active management often end up, which is if you were an active manager who was managing a fund that otherwise had a mandate for investment grade corporate bond exposure, chances are you have the flexibility in your mandate to still hang on to something that may have just gotten downgraded.”
Many corporate bond mutual funds have a buffer of about 10 to 15 percent that can be below investment grade, he says. It’s reasonable to say these active managers can take advantage of some of these structural issues. Yet recently, active managers of bond funds haven’t outperformed. During the one-year period ending June 30, the majority of active bond managers investing in long-term government and long-term investment grade bonds underperformed their benchmarks, according to the U.S. SPIVA Scorecard.
Nadig believes the BBB problem is overblown, and the impact of increased downgrades on bond ETFs to be minimal.
“The bond market is pretty good at pricing risk,” he says. “As things get downgraded, they get a little bit oversold. They get a little cheaper. Their yields come up. Now all of a sudden they’re attractive high-yield bonds that don’t really have any additional risk, so people buy them up. It tends to self-regulate pretty well.”