A second wave of performance for BBB bonds?

Juliet Schooling Latter 24/11/2020 in Fixed income

Forget A, B or C… BBBs are all the rage at the moment in the alphabet soup of fixed income.

Corporate bonds – or loans issued by companies – are rated by different agencies. One of them – S&P – has a scale from AAA to D. The former are bonds of the highest quality and have an “extremely strong capacity to meet financial obligations”. With the latter, the company has already missed a payment on its debt and is highly unlikely to repay what is outstanding. In between are AA, A, BBB, BB, B, CCC, CC and C.

BBB bonds sit on the lowest rung of the investment grade corporate bond scale, being of “adequate capacity to meet financial commitments, but more subject to adverse economic conditions.” But just one wrong move and they could be downgraded to BB and get a high yield or “junk” status.

Why does this matter?

Twenty years ago, BBB-rated bonds represented less than 10% of the corporate bond market. Today they are almost 50% – a huge part of the market and of a size that worried many people when we had the COVID downturn.

With many companies around the world unable to operate under lockdown, the fear was that many of these lowest-rated investment grade bonds would be downgraded and, as “fallen angels”, would swamp the high yield market, which is only fifth of the size.

For example, as Artemis Corporate Bond manager Stephen Snowdon pointed out: “The world’s largest issuer of corporate bonds is AT&T. It is rated BBB by S&P and if it were to fall on harder times and be downgraded to junk, at a stroke it would increase the size of the global high yield market by nearly 7%.”

But nine months on from the market collapse and this part of the bond market has been surprisingly resilient. While there are still a few weeks of 2020 left, only 2.5% of the sterling investment grade corporate bond market has been ‘junked’ and the news flow has become more positive.

And it’s an area of the market where many bond fund managers are finding opportunities. Eight Elite Rated corporate bond fund managers are overweight the area, as is one strategic bond manager.

Elite Rated corporate bond fund allocation to BBB-rated bonds*

Artemis Corporate Bond63.8%
BlackRock Corporate Bond55.6%
Liontrust Monthly Income Bond69.6%
M&G Corporate Bond 54.2%
M&G Strategic Corporate Bond65.1%
Rathbone Ethical Bond70.3%
Schroder Sterling Corporate Bond66.3%
TwentyFour Corporate Bond 65.3%

A second wave of performance in BBB bonds?

So why the preference for this part of the investment grade credit universe over other areas?

Richard Woolnough, manager of M&G Corporate Bond and M&G Strategic Corporate Bond funds, commented: “Generally, BBB rated bonds have provided something of a ‘sweet spot’ within credit. They are generally less vulnerable than high yield bonds in a recession – the 5-year rolling default rate for BBB rated bonds is around 1.5%, compared to 8% for BB rated bonds, 22% for B rated bonds, and 35% for CCC and lower rated bonds. They have also been relatively well-priced in 2020 (especially in the case of US dollar issues) and also have outperformed high yield.

“We continue to back the valuation signal offered by the BBB rated paper issued by companies with straightforward business models and fairly steady cashflows. And given the current market context, we maintain a relatively uncomplicated portfolio of plain vanilla bonds issued by companies at the higher end of the BBB rated universe. Names like Anheuser Busch, the US beer company, Boeing, the plane-maker, and British American Tobacco are all good examples of BBB rated companies that have either withstood the impact of the coronavirus recession or are well-positioned to rebound in the advent of a successful vaccine being distributed in 2021.”

Craig Veysey, manager of Man GLG Strategic Bond fund, which has 52.4%* exposure to BBB-rated bonds – more than double many of his peers – added: “The average valuation in credit is now quite expensive. But in the crossover space between investment grade and high yield, we’ve been able to find a number of opportunities among industry leaders.

“Ryanair is an example. The industry has been hit hard by COVID, but this company could survive 18 months even if it was completely grounded. Now we have had some good vaccine news, the outlook is better and if there is an airline industry after all this – which I expect there will be – Ryanair will be stronger.”

Stephen Snowden, manager of Artemis Corporate Bond fund, concluded: “While bonds have done very well this year, we could see a second wave of performance. Some parts of the market have not yet recovered. Global growth is still low, the population is aging and demand for corporate bonds in pensions will continue.”

*Source: fund factsheets, 31 October 2020

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