Life insurers invest heavily in high-grade corporate bonds to fund annuities, life insurance policies and other products. Here’s a look at the possibility that the issues might be affected by credit rating grade inflation…
Much has been made of the degradation of the $7.5 trillion U.S. corporate debt market. High yield offers too little, well, yield. And “high grade” now requires air quotes to account for the growing dominance of bonds rated BBB, which is the lowest rung on the investment-grade ladder before dropping into “junk” status. And then there’s the massive market for leveraged loans, where covenants protecting investors have all but disappeared.
How does that break down? Corporate bonds rated BBB now total $2.56 trillion, having surpassed in size the sum of higher-rated debentures, which total $2.55 trillion, according to Morgan Stanley. Put another way, BBB bonds outstanding exceed by 50% the size of the entire investment grade market at the peak of the last credit boom, in 2007.
But aren’t they still investment grade? At little to no risk of default? In 2000, when BBB bonds were a mere third of the market, net leverage (total debt minus cash and short term investments divided by earnings before interest, taxes, depreciation and amortization) was 1.7 times. By the end of last year, the ratio had ballooned to 2.9 times.
Given the marked deterioration in fundamentals, bond powerhouse Pacific Investment Management Co. worries that “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.”
In the event this warning rings a bell, be heartened that your memory is still largely intact. Investors blindly following credit rating firms’ designations on subprime mortgages despite a clear degradation in the due diligence upon which the ratings were assigned ended up regretting such faith when the financial crisis hit.