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.

Figure 3 – Unless the Sustainable GDP Picks Up, the Federal Reserve Runs the Risk of Overshooting in 2019

Perfect Storm Figure 3

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

 

If sustainable growth falters with the Fed’s projected rate path, the Fed runs the risk of overshooting by raising rates higher than what the U.S. economy can shoulder.
 
Asymmetric Risk For Fixed-Income Investors

The window for low cost borrowing on easy credit terms may be closing as the Fed remains committed to its rate hike schedule. Borrowing costs are likely to rise.   

The issue then becomes which speculative-grade borrowers can weather the higher costs assuming a benign macroenvironment.    
 
Even with the recent rise in BBB-rated credit spreads through the end of the seconnd quarter (Figure 4), the risks of owning corporate credit are becoming more asymmetric, especially in light of a flattening yield curve (10- vs. 2-Year U.S. Treasury yields).  

 

Figure 4 – Despite Widening During 2Q, Credit Spreads Remain Narrow Relative to Recent History

Perfect Storm Figure 4
ETF Investors Beware

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

 

The growing composition of BBB/Baa-rated issues held in many common corporate bond ETFs, such as the iShares IBoxx $ Invest Grade Corporate Bd Fund (LQD), is also contributing to this asymmetric risk profile. 

"Baa" bonds today represent about 45% of LQD, up from 36% in June 2015 (Figure 5), and that corporate credit asset class has grown riskier. Up until recently, the compensation demanded by lenders (i.e., credit spread) had shrunk to historically low levels before rising in the second quarter.

 

Figure 5 – Increasing Share of Baa Credit Risk in LQD

Perfect Storm Figure 5

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

 

Investors in fixed-rate preferred equity ETFs face even greater asymmetric risks because many preferred equity issues are now trading at negative yield-to-call or yield-to-worst levels. 

Using the iShares US Preferred Stock ETF (PFF) as a proxy, nearly 25% of the fund is invested in preferred issues trading at negative yield-to-worst levels, according to Bloomberg data. Fixed-preferred investors face heightened credit risk and prepayment risk. 

The macroeconomic and earnings backdrop may still look favorable for U.S. corporations, but a combination of Fed tightening, increasing risk of overshooting, and high corporate debt levels are leaving little room for error should the backdrop turns less favorable.
 
Investors in lower investment-grade credit risk should reassess whether the risks look more balanced in equities than in corporate credit.

Disclosure
At the time of this writing, 3D Asset Management did not hold positions in LQD and PFF. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete.

Past performance is no guarantee of future results. None of the services offered by 3D Asset Management is insured by the FDIC and the reader is reminded that all investments contain risk. The opinions offered above are as July 18, 2018 and are subject to change as influencing factors change.

More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2 which is available upon request by calling (860) 291-1998, option 2 or emailing [email protected] or visiting 3D’s website at www.3dadvisor.com.

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