Heading into this year, there was considerable consternation among fixed income experts regarding the fate of BBB-rated corporate debt, or those bonds residing within one to three notches of junk territory. Those concerns were warranted. After all, the U.S. corporate debt market is massive.
At the start of last year, that market stood at $5.8 trillion in value. Said another way, that's more than five Microsofts (MSFT). Moreover, the percentage of bonds with tenuous grasps on investment-grade ratings has surged over time to 48 percent at the end of 2017 from 25 percent in the 1990s.
To make a long story short, as the Federal Reserve raised interest rates four times last year, some bond market observers fretted that issuers behind BBB-rated debt could be pinched if the economy slowed because many of those companies took advantage of low interest rates and issued more debt. Then downgrades could come, forcing trillions of dollars of once IG debt into junk territory.
Conversely, other bond market observers argued that the above thesis was probably overblown and noted that the largest issues of BBB-rated bonds are defensive companies, such as financial services and consumer staples. Eight months into 2019, it looks like the latter camp is winning and to the benefit of exchange traded funds (ETFs), such as the Vanguard Total Corporate Bond ETF (VTC).
Reflective of the state of the domestic IG corporate bond universe, 51 percent of VTC's nearly 6,000 holdings resided in the BBB category. Indicative of investors' renewed thirst for yield due to the Fed's new found taste for lower interest rates, VTC is up 11.34 percent year-to-date and hit a record high on Monday while yielding 3.36 percent.
Yes, Really 6,000 Bonds
VTC really does hold almost 6,000 bonds by way of its ETF of ETFs structure. The fund holds the three other Vanguard corporate bond ETFs – the Vanguard Short-Term Corporate Bond ETF (VCSH), Vanguard Long-Term Corporate Bond ETF (VCLT) and the Vanguard Intermediate-Term Corporate Bond ETF (VCIT).
VCSH is VTC's largest holding, but the fund's average duration is 7.3 years, putting it in intermediate-term territory. That duration is long enough for VTC to have been positively affected by the Fed's July rate cut. Since that news was announced, the Vanguard fund has traded higher by 3 percent while regularly notching all-time highs.
It's not surprising that bond investors are bidding U.S. IG corporates high this year and that VTC is benefiting from that trend.
“According to Bloomberg, there are reportedly over $15 trillion worth of bonds that are currently trading at a negative yield,” said Morningstar. “Currently, the yield on German five- and 10-year bonds are trading at a yield of negative 0.89% and negative 0.68%, just a few basis points from their historically most negative yields. The Swiss 10-year bond is trading at negative 0.93%, only a few basis points from its most negative yield historically, and the Japanese 10-year bond is trading at negative 0.23%, also only a few basis points above its all-time most negative yield.”
Translation: VTC's 3.36 percent yield looks compelling when measured against negative-yielding government debt.
Obviously, bond investors must assess the issuer's ability to pay its debts and to be fair, there has been deterioration in BBBs' interest rate coverage over the past six years, though today's interest rate coverage in this corner of the corporate bond space is higher than it was at the start of this century.
Even if there is a sudden downturn in the U.S. economy, VTC may be able to endure some of that punishment because many BBB-rated issuers could move to retain their IG status by selling assets, suspending dividends or reigning in other spending to adequately service their debt. Plus, revenue growth for many BBB issuer isn't intimately correlated to U.S. economic growth, according to Goldman Sachs.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.