In the fourth quarter of 2011, long BBB-rated corporate bonds saw their yields fall to the lowest level since the second quarter of 1967 in an index provided jointly by the Federal Reserve Bank of Saint Louis and Moody's Investors Service. Given that BBB (Baa in Moody's ratings nomenclature) credit spreads do widen substantially amidst economic downturns as credit markets constrict, investors in BBB bonds or bond funds should consider moving up or down in quality dependent on their own market outlook.
If investors are using BBB bonds for their diversification benefit relative to riskier asset classes, they might wish to move up in quality as the relative credit spread between Treasuries and A or better rated corporate bonds has narrowed. If investors are more constructive on the markets prospectively, they may wish to move down the credit curve to BB-rated bonds to capture incremental spread for muted risk of additional credit losses. BBB-rated bonds uniquely appear relatively expensive to both market optimists and pessimists.
The Trade in BBB Bonds for Bulls
If you believe that the macroeconomic picture is brightening and credit market stress is subsiding, you should move to riskier asset classes. In a recent article, I depicted BB-rated bonds as the high yield "sweet spot" over the long-term given a yield pickup disproportionately larger than the incremental credit risk. BB-rated bonds currently yield 2.08% more than BBB-rated bonds, but the trailing ten years has seen one year credit losses of only an additional 0.27%. The incremental spread currently paid to BB bondholders over BBB bondholders is greater than its historical average in this period of low realized corporate defaults.
The cyclicality of investment returns is demonstrable in an examination of the returns by relative credit ratings. When the economy is recovering and expanding, lower rated bonds outperform. In a flight to quality environment, higher rated bonds perform better. In 2011, BBB bonds outperformed all of the high yield ratings cohorts (BB or lower). However, bonds rated BBB have not outperformed BB rated bonds for two consecutive years over the trailing twenty year period.
The Trade in BBB Bonds for Bears
If you believe that the macroeconomic picture is bleaker than recent equity and credit market gains have signaled, or believe that a credit crisis could emanate out of Europe, you probably want to rotate out of BBBs and into Treasuries or A or better rated bonds. As seen below in the correlation study of bond returns by ratings cohort and the S&P 500 returns over the trailing twenty years, the positive correlation with equities greatly dissipates as you move up in quality. Credit spreads on BBB bonds have retraced most of their credit crisis widening.
The run-up in BBB bond prices can be seen in recent corporate issuance. On February 16th, Teck Resources (TCK), a Canadian metals and mining company, issued seven-year notes at 165 basis points over the Treasury curve to yield just over the three percent coupon and thirty year bonds at 210 basis points over the thirty-year Treasury to yield 5.23%. These new issues redeemed 9.75% notes maturing in 2014 and 10.75% notes maturing in 2019 issued in July 2009. The 2009 vintage bonds were issued at roughly five point discounts. In less than three years, Teck Resources was able to issue debt an additional twenty years out the curve for half of the former coupon. In all fairness, the credit profile is materially improved and has warranted a three notch upgrade at Moody's from Ba2 to Baa2 over that time period as the company sold an equity stake to China Investment Corporation, refinanced senior secured notes, and further reduced debt as metals prices rebounded. The metals space also saw Baa3/BBB rated Freeport-McMoran (FCX) issue five year notes on February 8th to yield 2.175% and ten year notes to yield 3.58%. Even before the credit crisis, then below investment grade rated FCX issued ten-year debt at 8.375% in March 2007.
Enterprise Products (EPD), one of the leading midstream energy service companies in North America and the largest publicly traded energy partnership, issued thirty-year debt on February 8th with a 4.85% coupon, down from its 7.55% coupon on similar maturity debt issued in September 2009. The thirty year Treasury is down roughly 100 basis points over that time frame, so over sixty percent of the pricing differential is due to tighter credit spreads. Harley Davidson (HOG), the motorcycle maker, issued five year notes at 2.7% at the end of January, following a similarly sized five year deal ten months earlier that yielded 3.9%. During the credit crisis, the company sold a $600mm issue to Berkshire Hathaway at 15% after being frozen out of credit markets.
While the credit profiles of each of these companies are meaningfully improved, the disparate coupons show how far BBB bonds have rallied in just the last three years. While the credit spread over the credit curve will ultimately provide adequate compensation for the low default risk of these BBB industrials, the middle part of the credit curve is a suboptimal place to position your investment portfolio.
The outlook for credit markets is decidedly asymmetric. Even if we do not get a quickened pace of economic recovery, which would favor below investment grade issues whose returns are more closely correlated with equities, and instead continue in this slow growth environment with continued accommodative monetary policy, credit spreads will slowly grind tighter, favoring investments down in quality. If we see major tension in credit markets emanating out of the European situation, BBB and lower credits will materially underperform.
With such potential polar outcomes, bearish investors may be better suited moving up in quality to a tail risk hedge portfolio of Treasury bonds and high quality corporates to get returns negatively correlated with equities; while bullish investors may potentially wish to move down in quality to capture additional credit spread tightening in lower-rated credits.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
