US Investment Grade Credit: A Buy or a Bubble?

Recent market stress surrounding trade policy, the US government shutdown, Brexit and recession fears has increased focus on the US investment grade credit market and its sharp rise in leverage in the post-crisis period. Invesco Fixed Income believes these concerns are best analyzed through the lens of the BBB-rated portion of the US investment grade bond market. Some investors worry that this segment is a ticking time bomb set to upend the US fixed income market. Credit spreads on BBB-rated bonds have widened 50 to 100 basis points in the past year.1 With a focus on BBBs, we tackle some important questions for investors: Is the recent sell-off in BBBs a sign of worse things to come, or has the market over-reacted? Are there stabilizing trends on the horizon?

Upward trend in leverage may reverse in 2019

Debt levels among US corporations have grown in the post-financial crisis period in response to a lack of organic growth, low interest rates, modest credit spreads and tax policy that restricted the use of overseas retained earnings. As such, companies have used incremental debt primarily to buy back stock, fund mergers and acquisitions, and increase shareholder dividends. This shareholder-friendly activity has, however, come at the expense of company credit profiles and has exposed the market to potential credit transition risks, in our view.

Going forward, we believe there are several reasons to expect a reversal in this leveraging trend, including a return to organic growth, higher interest rates, wider credit spreads and repatriation of foreign profits. As such, we expect to see less opportunistic funding as acquisition break-even points are higher and companies have increased access to internal capital. Companies are also experiencing increased investor scrutiny over elevated leverage profiles and are beginning to address their balance sheets more proactively. We expect CEOs to highlight their debt reduction efforts in much greater detail during future earnings calls. We also note that large companies have begun linking deleveraging success to CEO compensation. We believe these are very positive trends for investors in corporate credit.

Fed has credit growth in its sights

In addition, we believe issuers and investors have taken note of comments from the US Federal Reserve (the Fed) in its November 2018 Financial Stability Report, which highlighted concerns over the pace of credit growth, leverage and underwriting practices in the leveraged loan market.

Figure 1: Leveraged loan quality

Leveraged loan quality line graph, invesco

Source: S&P Global Market Intelligence, Dec. 31, 2004 – Dec. 31, 2018. Includes issuers with earnings before interest, taxes and depreciation (EBITDA) of more than USD50 million. In the graph series, “<4.00x” means “debt is less than 4.00 times EBITDA.”

The Financial Stability Report also highlighted that the distribution of ratings among investment grade corporate bonds has deteriorated, with a near-record number of bonds rated at the lowest investment grade. As of the second quarter of 2018, 35% of corporate bonds outstanding were at this level, amounting to approximately $2.25 trillion.2 The Fed noted that during an economic downturn, widespread downgrades of these bonds to speculative-grade ratings could force some investors to sell them rapidly, pressuring liquidity and prices in this segment of the corporate bond market.