investing

The Rising Risk in Corporate Bonds

The BBB-rated debt tier is increasingly populated by iconic but risky outfits you might not want to finance now.

Famished and desperate bond bears, starved for what they consider an overdue feast and riled by yet another rally in long-term Treasuries, have lately sniffed out an unfamiliar target: U.S. corporate bonds. Bond-return tables confirm a dismal year for investment-grade corporate debt. The slice of the market rated BBB by Standard & Poor’s, which I’ve often said stands for “buy, buy, buy” because of its wonderful long-term record, trailed junk, municipal and government bond returns in 2018, with a total loss of about 3% through December 7. Only dollar-denominated emerging-markets bonds did worse.

That’s not a life-changing loss. And you can attribute a chunk of it to the fact that at the end of 2017, U.S. corporate bonds were expensive relative to Treasuries. What happened is that the spread, or gap, between the yields on BBB bonds and 10-year Treasuries got unusually tight a year ago and has now widened, with corporate yields rising and prices, which move in the opposite direction, falling. That repricing of debt is the primary reason for 2018’s fizzle.

Poor returns last year were “really a function of bond math,” says State Street Global Advisors’ deputy chief investment officer Lori Heinel, who sees value again in investment-grade bonds. She forecasts “mid-single-digit returns” for 2019, which suggests a 4% to 5% yield (at current bond prices), with investors breaking even or gaining just a bit on principal. I’m a little less bullish, but BBB bonds have moved into the green again in recent weeks, so the worst may be over.

The bear case. The BBB bears do make some good points, however. There has been a massive increase in corporate bond issuance since the last recession. That in itself isn’t too worrisome because the bulk of those borrowers have loads of cash. But bonds rated BBB, the lowest quality considered better than junk, account for half of all investment-grade debt by dollar volume, a proportion that has grown nonstop from 10% in the 1980s. The market shares of AA and AAA bonds have shrunk accordingly; single-A bonds have held steady at about 35%.

Moreover, the BBB layer is increasingly populated by iconic but risky outfits you might not want to finance now. General Electric’s future is murky. General Motors can still sell trucks and SUVs but has a huge and idle fixed investment in cars. AT&T is America’s biggest corporate debtor. Pacific Gas & Electric could stumble if it is found liable for causing recent California wildfires and neither the courts nor the state legislature help it compensate victims. And CVS tripled its long-term debt, borrowing $40 billion to buy Aetna last year to experiment with the marriage of a health insurance company and a string of pharmacy convenience stores.

I’m not saying—and neither is Moody’s nor S&P—that any of these bonds are on the verge of being busted to junk. But that’s possible if the economy weakens. And when BBB debt gets downgraded, pension funds and mutual funds are forced to jettison the bonds, causing their market value to drop at a rate that could easily exceed 2018’s 3% loss.

Consequently, some fund managers, investment firms and familiar market commentators are chary about parts of the BBB universe. This supports my advice to avoid total bond market mutual funds and exchange-traded funds and consider actively managed bond funds that aren’t restricted to tracking or mimicking an index. These are often called multisector, strategic or nontraditional bond funds. Next month, I’ll detail my favorites.

Most Popular

In What Order Should You Tap Your Retirement Funds?
retirement planning

In What Order Should You Tap Your Retirement Funds?

Should you go with your IRA first or your brokerage account? Pulling money haphazardly can have negative implications. Instead follow this road map fo…
June 28, 2022
Your Guide to Roth Conversions
Special Report
Tax Breaks

Your Guide to Roth Conversions

A Kiplinger Special Report
February 25, 2021
An Easy Way to Find How Much You Will Spend in Retirement
retirement planning

An Easy Way to Find How Much You Will Spend in Retirement

One simple math equation can help you determine where to start building your retirement income plan, and whether your money should last.
June 27, 2022

Recommended

Move Over ETFs: Direct Indexing Is an Investment Strategy Worth Paying Attention to
investing

Move Over ETFs: Direct Indexing Is an Investment Strategy Worth Paying Attention to

More flexibility, more control, the potential for higher returns and tax-reducing strategies: With pros like that, could direct indexing be right for …
June 25, 2022
Dividend Stocks Are Paying Off for Income Investors
dividend stocks

Dividend Stocks Are Paying Off for Income Investors

Investors can weather the storm of a volatile market with dividend-paying stocks.
June 23, 2022
Smart Investing in a Bear Market
investing

Smart Investing in a Bear Market

Here's how to make the most of today’s dicey market.
June 22, 2022
Dogs of the Dow Are 2022's Best in Show
dividend stocks

Dogs of the Dow Are 2022's Best in Show

Some of the best investments for income investors in a volatile 2022 have come from the Dogs of the Dow.
June 22, 2022