With government bonds paying low single-digit interest rates, investors are turning to investment-grade corporate debt with lower-medium credit quality, which offer a boost of a couple of percentage points in yield – but with higher default risk. In turn, bond issuers are obliging with a flood of new debt as ultra-low interest rates have given companies incentives to borrow more and leverage their balance sheets.
Half of the investment-grade corporate bond universe is currently rated “BBB,” effectively the bottom of the space, says Chris Kresic, head of fixed-income and allocation at Jarislowsky Fraser Ltd. in Toronto.
“It’s a scramble for yield and, in Canada, there are more entrants into that space,” he says. “Utilities and pipelines [companies] have leveraged their balance sheets because of mergers and acquisitions. There are lower energy prices that have hurt the cash flow of the pipelines that transport oil from producers to customers. And in the U.S., there has been more leveraging of balance sheets because of stock buybacks.”
Very low interest rates have expanded the low-rated end of the debt market, according to a recent report from credit-rating agency S&P Global Ratings.
“The ‘BBB’ rating category is the largest among outstanding U.S. corporate debt instruments rated by S&P Global Ratings. ... With nearly US$3.2-trillion in bonds and notes, the ‘BBB’ category accounts for the majority of investment-grade bonds in the U.S.,” the report states.
In fact, this part of the markets is more than two-and-a-half times the size of the speculative-grade markets, the S&P report says.
The rush to load up on cheap debt has caused S&P’s credit-rating analysts to downgrade corporate debt at the fastest pace in four years. Yet, investors are not balking. Rather, they’re buying in.
On Oct. 19, Netflix Inc. issued US$2.2-billion of 10.5-year notes with a “Ba3” rating from Moody’s Investor Service Inc. That’s in the higher-end of non-investment-grade speculative ratings. The Netflix issue carries a 5.125 per cent coupon on U.S.-dollar-denominated debt and 3.875 per cent in euro-denominated notes. Compared with the going rates of 1.93 per cent on 10-year U.S. Treasury bonds, Netflix debt shines.
“Yields are so low that investors who recognize issuers’ names are buying for familiarity rather than for ratings that might warn them off,” says Edward Jong, vice president, business development, and a bond analyst at T.I.P. Wealth Manager Inc. in Toronto. “There’s a downward migration in the quality of bonds being launched and sold. Investors who take on this risk also wind up with wider buy/sell spreads and a tougher time selling. The wider the spread, the lower the liquidity.”
“The ‘BBB’ sector has grown,” says Robert Pemberton, managing director and head of fixed-income at TD Asset Management Inc. in Toronto, whose unit manages $175-billion in bonds.
Although he says that “there is more leverage in the system,” the Canadian corporate debt market is stable as there have been very few defaults in recent years.
Buying lower-quality bonds is not a natural move for investors who want to balance equity risk with bond safety. They don’t want to be bottom-feeders taking on unwanted bond risk. So, financial advisors have to explain the new world of low interest rates and low credit ratings to clients.
“We have conversations with our clients, many of whom are not aware of how low interest rates are,” says Benoit Poliquin, president and lead portfolio manager at Exponent Investment Management Inc. in Ottawa. “Most of our clients don’t want to swap equity risk for crummy paper. As advisors, we hesitate to push our clients into leveraged debt late in the interest rate cycle. After all, when investors take on speculative debt they get two risks – that interest rates will eventually rise, pushing up borrowing costs, and they get almost as much event risk in some industries like energy as if they were holding the stock.”
More lower-rated investment-grade debt is likely to come. As a recent S&P report states, “Lower borrowing costs have resulted in some voluntary migration down the ratings scale.” That’s because the companies that have issued these bonds have more levers to pull in times of stress, such as cutting dividends.
Moreover, the S&P report says that “the incremental increase in the cost of funding for moving to ‘BBB’ from ‘A’ or higher has been less severe in the current environment than it once was.”
Eventually, the piper will have to be paid. If there’s an economic downturn or an increase in interest rates, investors with bond holdings rated toward the lower-end of the “B” range will see red ink.