Growing Risk In Corporate Bond ETFs

July 23, 2018

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Ben Lavine, chief investment officer of 3D Asset Management based in East Hartford, Connecticut.

Investors exposed to lower investment-grade credit risk take note: there’s a perfect storm coming.

A tightening Fed, a flattening U.S. Treasury yield curve, and heavy corporate debt issuance from less credit-worthy borrowers are presenting an asymmetric risk environment for fixed income investors and corporate lenders. 

Business debt as a percentage of GDP has reached 72.3%, which has exceeded the last cycle peak of 68.8%, according to Grant’s Interest Rate Observer. U.S. businesses have little margin for error should the U.S. economy falter. 

Good for Equity Investors, Not So Good For Bond Investors
Consider AT&T, for example. The company epitomizes this borrowing binge as its total debt load has reached $249 billion ($189 billion funded by the markets), making it the most indebted non-government, nonfinancial-rated corporate issuer. This prompted Moody’s to downgrade AT&T’s senior debt from Baa1 to Baa2. 

AT&T prevailed in its anti-trust case against the Justice Department as a judge approved the acquisition of Time-Warner. This ruling may pave the way for other expensive, debt-fueled acquisitions as the media world races to lock in content. Equity holders cheered the decision, but bond holders may be left holding the borrowing bag.
Indeed, it’s never been a better time to borrow as U.S. Federal Reserve rate tightening is starting to close the window on easy financial borrowing. There are growing risks facing corporate and fixed preferred investors.

Figure 1 shows the U.S. investment-grade market has grown riskier over the last several years due to the higher composition of lower investment-grade borrowing. 


Figure 1 – Composition of BBB-Rated Borrowing Has Reached New Highs

Perfect Storm Figure 1
Source: Wells Fargo courtesy of Invesco

(For a larger view, click on the image above)


The good news for corporate lenders is that overall credit metrics still look benign, even for the most levered cohort of borrowers. Yet storm clouds are forming on the horizon for corporate lenders despite the positive fundamental backdrop for corporate earnings.

We believe one of the biggest risks facing corporate lenders is overshooting by the Fed (Figure 2).   


Figure 2 – Fed Funds Dot-Plot Projections Imply 2 Rate Hikes in 2018 and 2 More in 2019

Perfect Storm Figure 2
Source: Bloomberg

(For a larger view, click on the image above)


The risk to Fed overshooting is linked to whether the economy can grow sustainably without igniting inflation. A key input into that assessment is the Fed’s estimate of sustainable real GDP growth. The core component of the personal consumption expenditure (PCE) inflation has risen to 2% on a year-over-year basis, and is projected to rise to 2.1% at the end of 2018. That rising PCE has given the Fed cover to raise rates in a more hawkish manner than what the market is anticipating. But sustainable GDP growth will need to rise.

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