Moving Up in Credit Quality for Better Durability

As long-term investors, our credit research broadly focuses on determining if companies can service their debt throughout a credit cycle. In today’s crowded investment-grade (IG) space, our research also helps us distinguish overly leveraged companies from ones with manageable debt loads and durable business models. Within high yield, we are seeing a different dynamic compared to the enormous IG universe. Given shrinking supply, high-yield bonds have been enjoying positive tailwinds.

It’s quite a different story for the bank loan market, which now rivals high-yield in terms of size.1 With investor demand outstripping bank-loan supply, we are seeing more investors relinquishing control over credit terms. That could spell trouble down the road when the credit cycle finally shifts.

Investment-Grade Bonds

The IG seal of approval often conveys a status of safety that some investors might misinterpret. From our experience, we know these bonds can still be volatile if broader economic conditions deterio­rate, or for company-specific reasons. To better gauge the risks of one IG bond in comparison to another, some investors look at credit ratings from agencies like Moody’s and Standard & Poor’s. The vast majority of IG corporate bonds historically carried the highest quality ratings, like S&P’s AAA, AA and A designations.

The quality of the IG universe, however, has steadily declined in recent years. On the back of low interest rates, many companies issued more debt to fund projects, acquire new companies, and even buy back equity shares. As more companies overindulged in borrowing, leverage levels rose, and credit metrics fell. BBB rated bonds (the lowest rating in the IG universe) now make up nearly half of IG securities, up from 25% in the 1990s, as shown in the chart below.

Given the late nature of today’s credit cycle, some investors might think exiting the BBB rated universe entirely and moving up the credit rating scale is a good idea. We think moving up in quality makes a lot of sense. However, we don’t need to exit the vast BBB rated universe entirely, given our deep credit research. Through our own analysis, we look to pinpoint BBB rated companies that we believe have the potential to generate reliable cash flows, even within competi­tive and rapidly evolving industries.