Back in July, I posted about the shifting consensus on bond allocations for retirees as well as the phenomenon of the large amount of “barely” investment grade debt rated BBB. This lower level of investment grade debt has reached its peak of almost 60% of all investment grade bonds and the market is starting to catch on that the ratings agencies maybe inflating ratings again to pad their bottom lines.

Source: Deutsche Bank

Many market participants including Goldman Sachs and Morgan Stanley have been sounding the alarm since early 2019 that the corporate investment grade bond market was reaching unsustainable levels in terms of debt. JP Morgan pointed out that leverage, in terms of debt to earnings, for those companies that are considered investment grade is hitting 3.25 times earnings on average, up from just above 2 times earnings back in 2011.

Source: JP Morgan

Goldman Sachs took another view in a note to their investors and looked at net debt to assets of BBB rated companies and noted this figure was close to peaks seen in the early 2000’s before the dot com bubble burst.

Source: Goldman Sachs

Right now the economy is seeing choppy waters. The risk of recession is rising and many are starting to see the signals align. Retail sales took a hit last week and the IMF saw the risk of a global slowdown on the rise at their annual meeting in Washington this weekend.

Lower rates can work to save highly leveraged borrowers for the moment, with the Fed expected to cut rates another quarter point on October 30, many may be biding their time for even lower rates or taking their chances to refinance higher yielding debt now before the economy slows and earnings start to fall.

I think when we do start to see those earnings figures fall, which could happen this quarter or the next, then leverage ratios will jump even higher and you could see a wave of downgrades, especially in the low end of the investment grade spectrum around those BBB and BBB- names.

What This Means When the Shoe Drops

Moody’s estimates that in the course of a normal downturn, 10% of BBB- rates bonds get downgraded to junk. Given that the about $3.2 trillion corporate bonds carry the BBB- rating and that the entire corporate junk bond market is about $1.3 trillion in size, this could mean a flood of the junk bond market of an additional 25% more junk bonds right when earnings are under pressure and defaults will likely rise. This also means that at the same time that risk is increasing and prices will likely start to fall in the bonds that were already junk, a flood of “fallen angel” junk bonds could hit the market, further depressing prices. The “fallen angel” moniker is designated for those bonds which were previously rated investment grade and then were relegated to junk status by a downgrade.

Downgrades have big effects for bond prices because many bond ETFs, pension funds and mutual funds can only hold bonds that are rated as investment grade. A downgrade to below investment grade produces a wave of sell offs from institutional holders that usually drops a bond’s price and raises its yield. Impacting not only investors but the company themselves as they are now forced to pay much more for any new debt.

To give an example, two of the largest names to be downgraded from investment grade to junk recently were PG&E as well as Ford Motor Company. In the case of PG&E the stock price moved in line with the bond price and fell off of a cliff when it was announced that their bonds would be downgraded to junk.

Source: Zero Hedge

S&P provides a nice visual of the size of the investment grade market to the junk market where you can see how a portion of bonds getting downgraded to junk could exacerbate any problems that already exist in that market.

Source: S&P

A breakdown by rating category shows the bulge in the BBB space and the danger of the future flood of the junk bond market should earnings come under pressure in the investment grade space.

Source: S&P

So How to Profit From This?

As I discussed in another post, The Best Investment I Ever Made, I wrote about how I was able to patiently wait and invest in the market via my Roth IRA and a mutual fund almost at the bottom of the market in 2009.

What I didn’t talk about was some of the other investments I made which also turned out to be lucrative. These included investments in some of the large banks such as Bank of America, Wells Fargo and US Bancorp. I also invested some in junk bonds as default rates spiked and prices plunged. The following year, the junk bond market recovered and all the while I saw my investment there make a handsome capital return as well as continue to pay me a great yield on what I initially invested.

I was very fortunate and my patience paid off but there was one thing I wish I had done different and that was profit on the way down as well as the way up. I realized I had a good grasp that economy was in for a tough time, yet I did not short the market or buy any puts to hedge my portfolio against any large losses.

When those earnings do start to take a hit for many of these weak investment grade companies, buying puts on large corporate bond ETFs like VCIT and LQD or even shorting these may prove profitable. You could also short or buy puts on some of the junk bond funds and ETFs like JNK and HYG. Then turning around and purchasing the underlying funds once you have made a profit from the puts or the shorting.

A Note on Bond ETFs

There is an important note which I also have been alluding to in some of my other posts. I find bond ETFs to be quite inefficient because they essentially have extremely liquid liabilities in the shares their investors hold but much less liquid and longer dated assets. This is especially true in the long term and intermediate term corporate bond ETFs. If there is too quick an outflow and the provider is not able to sell the underlying bonds in time will we see further price implosion in a desperate attempt to meet investor demand for cash? Or will there be some controls placed on the liquidity of shares which would gives the provider time to sell down the underlying assets at a more reasonable price? It remains to be seen how a scenario like this could play out for those with securities linked to these ETFs like those with short positions or puts.

Conclusion

Much like the housing crisis over 10 years ago, many people know it’s going to happen but it takes a certain catalyst to actually push things downward. Will a poor earnings season in the next quarter start the tumble of investment grade debt and spell trouble in the junk market? Only time will tell.

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