BBB Securities: A Reach for Yield with Long-Term Repercussions?

 In Market and Investment Insights

As investors seek higher returns following a long period of significantly low rates, issuers are taking advantage by issuing longer-term debt for lower-rated securities, notably in the BBB sector. In this video, Portfolio Managers Nick Maroutsos, Dan Siluk and Jason England discuss the risks presented by a large influx of BBB-rated securities.

Key Takeaways

  • In a risk-off environment, the likelihood is that the BBB sector would suffer more than higher-rated securities.
  • While we do feel that investors are compensated for the additional risk, not all BBB is the same, and compensation is tied to sectors, industries and countries.
  • We’re closely monitoring any indicators of a potential recession and how those indicators could impact the BBB space.

Nick Maroutsos: There has been a proliferation of BBBs being issued in the marketplace, and I think it’s for a variety of different reasons

You have an environment where people are reaching for yield. They want to achieve higher returns for their portfolios, and you’re also in an environment where rates have been significantly low for a long period of time, and issuers are taking advantage of that by issuing longer-term debt at lower-rated securities. Now, as we move down the capital structure from AA to A to BBB, you’re obviously increasing the risk of your overall portfolio, and you’re only one notch away from some investment grade, which certainly takes on more characteristics and more equity-like characteristics. So if there were a risk-off environment, the likelihood is that the BBB sector, at least in the investment-grade space, would suffer more than higher-rated securities such as A- or AA-rated securities.

Dan Siluk: Are investors being compensated for BBB risk? Well, not all BBBs are created the same, so you’ve got this disparity between a BBB+ credit versus a BBB- credit, for example. So the rate of default on a BBB+ credit is roughly 2% versus the BBB-, which is around 10% annualized. So it really depends where you sit within that BBB universe. The lower you go down the capital structure, you’re expected to be paid for the additional risk you’re taking. So we do feel that investors are compensated, but they’re compensated within various sectors, industries and even countries around the globe.

Jason England: It’s hard to argue that the next recession is not far off. Some of the indicators that we’re looking at obviously is the yield curve as we’ve seen two’s and ten’s spread is shrinking, it’s, you know, around 20 basis points. As that continues to get closer to flat or maybe even as the curve inverts, that’s one tipping point or telltale sign in the past that has told us when the next recession is. So that’s something we’re monitoring closely, and if we see that, that’s where you could see an impact to the BBB space.

Maroutsos: In a risk-off environment as a result of the proliferation of the large-scale issuance in the BBB sector, naturally, you’re going to have a spread-widening event, and the BBB sector will suffer the most in the investment-grade space. If we do see some downgrades in the investment-grade space, naturally, the lower-rated BBBs are going to suffer the most. So they will behave more like equity-related securities, so they won’t provide the true defensive nature that a fixed income security is there to provide. If you look at the BBB sector as a whole, so statistically showing that the investment-grade corporate bond market is about $6 trillion in size, as of now, roughly half of that is comprised of BBBs. If we take a step back to 2008, there was only a third of the assets that were BBBs, so there has been a large influx and issuance of BBB-related securities and, naturally, people have gravitated to that in order to accept more yield and, ultimately, try to get more return in their portfolios.

Fixed income securities are subject to interest rate, inflation, credit and default risk. As interest rates rise, bond prices usually fall, and vice versa. High-yield bonds, or “junk” bonds, involve a greater risk of default and price volatility. Foreign securities, including sovereign debt, are subject to currency fluctuations, political and economic uncertainty, increased volatility and lower liquidity, all of which are magnified in emerging markets.
Basis Point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.
Credit Spread is the difference in yield between securities with similar maturity but different credit quality.
2’s and 10’s spread is the difference in yield between 2-year Treasuries and 10-year Treasuries.
Bond ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest).

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