Looking for a little bit more return but still don’t want a lot of risk? Try expanding your investment policy to include BBB corporate bonds, says Capital Advisor’s Lance Pan in a recent report. BBB corporate bonds actually are only “moderately” riskier than their better-rated cousins, but at the end of the day, will offer higher returns.
With the popularity of money market funds waning in light of coming regulation that will limit eligible supply, “BBB-rated securities introduce an additional source of supply unavailable to most money market funds,” writes Mr. Pan, who is the director of research at Capital Advisors.
Still, not all BBBs are created equal, Mr. Pan says. That’s why treasurers managing the company’s portfolio should “steer clear of BBB financial issuers.”
“The vulnerability of BBB-rated [financial] firms lies in their greater reliance on wholesale market funding,” Mr. Pan says. “The funding tends to deteriorate rapidly once investors lose confidence in a particular name which may lead to its insolvency rather quickly. Bear Stearns, Lehman Brothers and CIT also faced similar situations.”
But BBB non-financial corporate debt doesn’t have that baggage and offers a little bit of the safety of other investment-grade products. “When we speak of BBB-rated securities, we are referring to debt instruments still of investment grade quality, albeit at the lower rung of the credit ladder,” Mr. Pan writes. In other words, BBB corporate debt, while being the last stop before entering into “below investment grade” or even “junk” territory, still means its investment grade.
What’s more, Mr. Pan notes, is BBB paper has a good track record over the last few years. According to his report, “the BBB segment of the debt market has grown significantly. With the Merrill Lynch 1 to 3 Year Corporate Index as a proxy, total face value tripled from $335 billion in December 2005 to $1,075 billion in May 2015. The number of issues in the index doubled from 619 to 1,364.”
However, in considering BBBs, treasurers should note that the market is still small overall; thus liquidity could be problem here, too. “Although BBB-rated corporate securities are of investment grade quality, market acceptance tends to be more limited,” Mr. Pan writes. “The lower acceptance often leads to lower secondary market liquidity as fewer potential buyers are available.”
So how should treasuries go about changing policies (if need be) to capture the returns BBBs can offer? First, since the investment is not for all portfolios, treasurers should do their due diligence and assess the pros and cons of suggesting BBB to management. Also a good idea is to see what others in your industry are up to when it comes to investments as well as see where the portfolio currently stands. “BBB names are not for everyone,” Mr. Pan says. “Peer review is a good practice. But risk assessment should start with self-appraisal of liquidity needs and loss tolerance. External managers may help with the appraisal process.”
In terms of that external appraisal, Mr. Pan cautions that ratings are a good start, but more work needs to be done. “Ratings may be the first line of defense,” he writes. However, “they should not be the last.” Still, BBBs could be the solution to the problem treasurers have faced since the start of the financial crisis – namely, ZIRP, which means virtually zip for returns. “BBB-rated corporate bonds have the positive attributes of broader supply, improved risk diversification, moderate default and ratings migration risk and attractive yield potential.”