A corporate bond is a debt security issued by a corporation that wants to raise cash for Merger and Acquisition (M&D) activity, to expand its ongoing business, to support current operations, etc. It would be highly time consuming for average investors, like you and me, to go through hundreds and thousands of these corporate bonds to identify the “good” from the “bad” bonds. So, to make our search easier, ratings agencies such as Standard and Poor’s, Fitch, and Moody give these bonds a rating. Although the letter based grading (shown in table below) might vary from one rating agency to the other, the gist is still the same. Bonds with BBB rating or better are considered investment grade, and any bonds worse than BBB are considered “junk” bonds. In this week’s blog post, I will be focusing on BBB Corporate bonds, since these investment grade bonds are 1 rating downgrade from junk status.
According to Bloomberg Barclays global corporate bond index, BBB bonds make up more than 50% of 2019’s investment grade debt. So, if you have invested your money in investment grade corporate bonds within your retirement or personal accounts, then you definitely have exposure to BBB bonds.
Since BBB bonds have a higher yield than A, AA, and AAA bonds, BBB bonds come with the risk of being downgraded into junk status. Especially during a recessions, when monetary supply tightens up and profits diminish, corporation have a tough time making payments. If these BBB bonds received a downgrade, then the investment grade corporate bonds ETFs and mutual funds would have a month to liquidate those BBB bonds that were dropped to junk status.
So, what are the real implications of being downgraded to junk status? Well, you can think about your personal credit score. If you have a credit score of 750, you are a going to have an easy time borrowing money, getting better terms while re-financing, etc. On the other hand, if you had a credit score of 500, life would be a lot harder. Similarly, when a company’s corporate credit is downgraded to junk status, liquidity dries up for that company.
As you can see in the graph above, the BBB rated bonds (red) ballooned from about $800 billion in 2007 to about $3 trillion in 2018. According to the balance, the default rate among B-rated issues has been 4.28%. So, 4.28% of $3 trillion would equal to about $128 billion dollars. Now, this might not seem like a lot in the grad scheme of things, and it is not. It is important to note that corporations can still receive a downgrade without defaulting on their obligations. Deteriorating finances (high debt levels) is one of the key reasons why companies face credit ratings downgrade. Worsening finances show that the corporation may not be able to service its debt obligation on schedule. A downgrade not only affects the credit worthiness of the company, but it also negatively affects the stock price of the company.
In the video below, you can watch Federal Reserve chairman Jerome Powell addressing the business debt issue and that businesses should start reducing their debt while times are good.
Some individuals predict that defaults associated with BBB bonds is going to be the catalyst for the next recession. Personally, I do not foresee that happening, especially when interest rates are low and refinancing debt is “cheap”. We could potentially see the corporate default rates increase if the Federal Reserve starts tightening and raising interest rates. Nonetheless, corporate debt has definitely grown and is a cause of concern. I do not know when the next recession will be, but I do know that this ballooned corporate bond debt is definitely going to make things worse during the next downturn.
Hope you learned a little and found this blog post helpful. We talked about BBB investment grade corporate bonds and how a rating downgrade can make things worse for a company. As always, you can sign up for our free mailing list here. You can sign up for our paid subscription services here. Like us on our Facebook page here. Thank you!
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