Credit Migration Risk and the Growing Glut of BBB Debt

Pierre Couture

Pierre Couture, A.S.A., E.A., M.A.A.A.

Senior Actuary and Portfolio Manager

Brett Cornwell

Brett Cornwell, CFA

Client Portfolio Manager, Fixed Income

Executive Summary

  • For plan sponsors, inflection points in a credit cycle can have a dramatic impact on corporate bond portfolios constructed to hedge expected liability cash flows.
  • Against a backdrop of growing BBB issuance, many plan sponsors are focusing on minimizing credit migration risk as they build, implement and manage de-risking strategies.
  • In the analysis that follows, we provide an overview of the current corporate credit landscape and offer solutions to help plan sponsors minimize credit migration risk.

Plan sponsors expanded their investible universe in a benign credit environment—now what?

To hedge against movements in liabilities, plan sponsors historically sought to replicate the performance of the AA-rated long-duration corporate bond universe used to discount the plan’s liabilities for accounting purposes.

However, most plan sponsors have come to recognize that perfectly replicating the cash flow discounting process is impossible. Investors are subject to principal losses from credit events, while the factors used to discount cash flows are not. Essentially, the discount rate has no memory of downgrades.

Accordingly, over the last decade many plan sponsors have judiciously expanded their opportunity set to include bonds in the lower-rated segments of the investment grade spectrum. At this stage of the cycle, concerns about credit migration risk have returned, especially with the surge of BBB issuance in the last decade (Figure 1).

Figure 1. What Does the Growing Glut of BBBs Mean for Plan Sponsors?

Figure 1. What Does the Growing Glut of BBBs Mean for Plan Sponsors?

As of 09/30/2018. Based on total market value.

Source: Bloomberg Barclays. BBB as represented by the Bloomberg Barclays Baa Corporate Bond Index. High yield as represented by the Bloomberg Barclays High Yield Index.

The risk in BBBs—a more balanced perspective than headlines might imply

On the surface, the sharp increase in BBB-rated debt seems concerning, particularly against a backdrop of higher net leverage and declining coverage ratios.

While risk is present, we do not believe a downgrade cycle is imminent. Although leverage has increased for investment grade companies, much of this increase has been the result of M&A transactions by larger companies that have several levers to pull to ensure they remain investment grade. We have also observed that many of these companies are higher quality companies that operate in defensive sectors, which should help insulate them from an economic downturn. More broadly, credit markets are still being supported by strong corporate earnings, as positive revenue and EBITDA growth are helping offset higher net leverage and declining coverage ratios.

As the credit cycle has extended, there is increasing concern about BBBs and their growth. We believe for good reason:

  • The growth in BBB-rated public corporate bonds has grown by 265% since 2007
  • BBB-rated bonds with maturities greater than 10 years have experienced the most pronounced growth, increasing by 270% over the same time period
  • The higher level of long duration BBB debt is particularly concerning in the absence of natural buyers of long-dated high yield debt that is now nearly as large as the entire high yield market

Despite the dramatic growth in BBBs, we do not believe there is an immediate threat to the broader credit markets. However, for liability hedging portfolios, exploring ways to diversify credit risk without increasing the basis risk between the assets and liabilities is critical in this environment.

Historical perspective: Fallen Angels and BBB defaults

Default rates for BBBs are rarely reported due to their infrequency across all investment grade (IG) bonds. When defaults do occur, they are typically due to extraordinary events; e.g., the Enron and WorldCom fraud and more recently the 2008 financial crisis. As of December 31, 2018, there have been no IG defaults over the last three years.

According to information from Bank of America, IG default rates peaked at 1.55% following the great depression. More recently, we saw issuer-weighted defaults spike in 2002 (0.43%) and 2008 (0.63%). Since 1920, the average annualized IG default rate is 0.14%.

Ratings transitions between investment grade and high yield happen more frequently, but are still driven primarily by idiosyncratic or industry specific risks; e.g., the recent oil price sell off and ensuing volatility in commodity markets (Figure 2).

Figure 2. Idiosyncratic Risk has Driven Historical Spikes in Fallen Angels

Figure 2. Idiosyncratic Risk has Driven Historical Spikes in Fallen Angels

Source: Deutsche Bank. As of December 31, 2018.

Minimizing credit migration risk: What is a plan sponsor to do?

There are a variety of options to mitigate credit migration risk. One key method is to simply diversify the corporate exposure through allocations to U.S. Treasuries and other government bonds. Another method is for plan sponsors to expand their investible universe and consider non-traditional long duration instruments like Investment Grade Private Credit and Agency CMOs.

Diversify BBB risk with Investment Grade Private Credit

Long-term oriented investors have multiple ways to mitigate the growing exposure to BBB in the public bond market. Given the track record of the Investment Grade Private Credit asset class during downturns, complementing public BBB credit exposure with Investment Grade Private Credit can help enhance the risk profile of a plan sponsor’s credit portfolio. In addition to diversification benefits, investors gain access to higher upfront spreads, ongoing prepayment and amendment income, and potentially lower losses. However, it is important to be aware that adding Investment Grade Private Credit bonds may slightly increase the portfolio’s tracking error to the liability in normal times. It will depend on how the sector and sub-sector allocations of the bonds in the portfolios compare with those used to create the Aa-rated corporate bond yield curve used to calculate the liability value. However, during periods of low spreads and potentially increasing downgrade and default risks, having bonds with strong covenants that have historically provided higher recovery rates has the potential to produce better returns than a portfolio with just public bonds. As a result, since the liability can neither default nor get downgraded, we believe a corporate bond portfolio that includes investment grade private credit should produce returns that better match those of the liability.

Securitized Assets provide the ballast of Treasuries with additional diversification benefits

Securitized assets can also enhance diversification and mitigate downgrade risk. It is possible to construct a portfolio of securitized assets that matches the duration of the liabilities and consists primarily of Agency CMOs with allocations to non-Agency RMBS and CMBS that can further diversify the corporate credit exposure without giving up yield. Recently, we worked with a client to construct a portfolio that consists of 80% Long Agency CMOs, 14% CMBS, 4% Non-Agency RMBS, and 1% Cash. The cash serves as collateral for the derivatives that are used to match the duration of the liability. This portfolio achieved a higher yield than the corporate benchmark used in the analysis (BofAML 10+ Year AAA-A Corp. Constrained Index) without eroding any of the diversification benefits of the Agency CMO allocation.

Conclusion

LDI implementation strategies will continue evolving to take into account the changing regulatory and market conditions. As pension plans mature, their liability cash flows become more predictable; i.e., most participants are in pay status. This will encourage plan sponsors to invest the bulk of their plan assets into fixed income strategies that more closely match liabilities.

In the current market environment, we believe managing funded status volatility is critical to the success of any de-risking strategy. Plan sponsors should mitigate potential credit migration risk by expanding their investible universes and considering substitutes for long public corporates.

Voya advocates the use of Investment Grade Private Credit and Securitized Credit as effective alternatives for plan sponsors’ overall de-risking strategy. Investment Grade Private Credit can enhance the risk profile of a plan sponsor’s credit portfolio and provide much needed diversification from BBB public bonds.

Meanwhile, Agency CMOs coupled with securitized credit sectors like non-agency RMBS and CMBS can add diversification to a portfolio without forcing a plan sponsor to sacrifice yield.

While this represents our high-level view, the nuances of applying these strategies will depend on the objectives of each plan sponsor. Taking corporate credit exposure and risk in structured credit must be informed by the prevailing portfolio allocations. Decisions around duration and illiquidity must be mindful of liability characteristics. We offer these viewpoints as a basis for discussing how we can meet the unique needs of each plan sponsor in what remains a challenging investment environment.

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Investment Risks

All investments in bonds are subject to market risks. Bonds have fixed principal and return if held to maturity, but may fluctuate in the interim. Generally, when interest rates rise, bond prices fall. Bonds with longer maturities tend to be more sensitive to changes in interest rates.

All investing involves risks of fluctuating prices and the uncertainties of rates of return and yield inherent in investing. High Yield Securities, or “junk bonds”, are rated lower than investment-grade bonds because there is a greater possibility that the issuer may be unable to make interest and principal payments on those securities. As Interest Rates rise, bond prices may fall, reducing the value of the share price. Debt Securities with longer durations tend to be more sensitive to interest rate changes. High-yield bonds may be subject to more Liquidity Risk than, for example, investment-grade bonds. This may mean that investors seeking to sell their bonds will not receive a price that reflects the true value of the bonds (based on the bond’s interest rate and creditworthiness of the company).

Disclosures

This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities. Past performance is no guarantee of future results.