he U.S. corporate bond market is a massive, diverse asset class that has seen decades of significant growth. In the past four years alone, the market has increased from around $4 trillion to $5.8 trillion. This growth, however, has been accompanied by a steady decrease in overall credit quality. Investors should watch this trend closely, especially when weighing the potential risks and benefits of passive versus active management in their credit portfolios.
Crucially, the share of the U.S. investment grade (IG) nonfinancial bond market that is rated BBB (i.e., the lowest credit rating still considered IG) has increased to 48% in 2017 from around 25% in the 1990s. Drilling down into the riskiest part of the BBB market segment, the universe of low BBB rated bonds is now bigger than that of all BB rated bonds (i.e., the highest-rated speculative grade bonds) combined. (Read our investor education piece on corporate bonds for a quick refresher on credit ratings, issuers, credit spreads, risks and reasons to invest.)
Average credit fundamentals also declining
Back in 2000, net leverage of BBB rated nonfinancial corporates was 1.7x on average; in 2017, net leverage for these companies was 2.9x (see Figure 1; net leverage is defined as (total debt – cash – short term investment) / EBITDA (i.e., earnings before interest, taxes, depreciation and amortization)). This suggests a greater tolerance from the credit rating agencies for higher leverage, which in turn warrants extra caution when investing in lower-rated IG names, especially in sectors where earnings are more closely tied to the business cycle.
The higher leverage among U.S. investment grade issuers should also be seen in context: Back in 2010, only 6.6% of the IG nonfinancial market had net leverage greater than 4.0x, but as of 2017, that share increased to 19% (see Figure 2). In addition, only 26% of IG nonfinancial debt is leveraged less than 2.0x as of 2017, compared with 55% in 2010.