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The market in investment-grade bonds is increasingly dominated by the very lowest-quality debt that qualifies for that rating.
That could cause problems as investors stock up on bonds more prone to default or to quickly losing their value should credit conditions turn.
The portion of global corporate bonds rated triple-B has roughly doubled in a decade, and now makes up nearly half of all investment-grade credit.
The share of triple-B rated bonds in the U.S. has recently surpassed its 2002 peak, climbing above 47% of all investment-grade credit. Around 48% of bonds in the eurozone are rated triple-B, while less than 20% where when Lehman Brothers collapsed.
Triple-B debts securities are the last rung on the investment-grade ladder. A downgrade to double-B sees a company’s bonds enter high-yield or junk indexes instead.
This triple-B supremacy has been flagged in the International Monetary Fund’s latest global financial stability report as an example of the relentless hunt for yield among bond investors.
“Low yields, compressed spreads, abundant financing, and the relatively high cost of equity capital have encouraged a buildup of financial balance sheet leverage,” says the report.
Ultralow interest rates and massive bond buying by central banks has pushed financing costs down for companies raising money in bond markets. The yield on Bank of America Merrill Lynch’s global corporate BBB index is just 2.89%, compared to a 20-year average of more like 5.1%.
What’s more, the spread between the highest and lowest-rated investment grade credit has collapsed. In 2008, during the financial crisis, triple-B rated bonds yielded over 8%, over four percentage points more than AAA-rated debt.
On Wednesday, that spread was just 0.25 percentage point.
That could be bad news for investors if credit conditions turn. Default rates on any investment-grade credit are very low, but they vary between different ratings levels.
For triple-B rated companies, the highest one-year global default rate was 1%, reached in 2002, according to S&P Global Ratings. In comparison, the default rate for AAA-rated bonds has been 0% in every year since 1981, even during the financial crisis.
Investors with more triple-B’s could also expect more volatility. During 2008, Bank of America Merrill Lynch’s BBB Global Corporate Index fell in value by around 15%, while the AAA index ended the year flat.
With the gap between yields currently so thin, investors are offered very little protection against a market panic, or even against a small rise in default rates, which have been low for the last five years.