A huge swath of the corporate bond market is looking increasingly vulnerable.
Bonds with the lowest investment grade have been a market darling over the past decade, ballooning in size as low global interest rates drew fund managers seeking higher returns. But as borrowing costs climb to a four-year high just as investors begin to anticipate a downturn in the global economy, some analysts are starting to sound the alarm.
“We’re late in the credit cycle, and trying to figure out when everything turns,” said Erin Lyons, a senior credit strategist at New York-based research firm CreditSights Inc. “Some of these may eventually be downgraded.”
Notes in the lowest rungs above high-yield junk -- in the BBB group from S&P Global Ratings or the Baa bucket from Moody’s Investors Service -- total about $3 trillion, almost the size of Germany’s gross domestic product. The concern is that as rates rise it will cost companies more to roll over their obligations, and if earnings begin to slump as economic growth slows, that could blow out leverage ratios and lead to credit-rating cuts.
The high-grade bond market in the U.S. already has the lowest credit quality mix since the 1980s, according to CreditSights, and there are signs investors are getting nervous. A Bloomberg Barclays gauge of average corporate bond spreads has surged to a six-month high since since reaching an all-time low in early February.
“We’re wary of companies that have seen their debt-to-equity ratios deteriorate,” said Tim Ng, the chief investment officer at New York-based Clearbrook Global Advisors, which advises on $28 billion of assets. “As interest rates increase, if they go too high, the higher debt-to-equity ratios and leverage will have a negative effect on cash flows.”