In its Financial Stability Report, the Fed noted that the share of investment-grade debt classified at the low end of the range has "reached near-record levels" of $2.25 trillion, or about 35 percent of total corporate bonds. The Fed's analysis of balance sheets at companies with debt in this rating tier indicated that over the past year, it has been firms with high leverage, high-interest expense ratios, and low earnings and cash holdings that have been increasing their debt loads the most. The report also warned of a potentially "large plunge in asset prices" and indicated that financial distress could "'trigger a broad adjustment in prices of business debt," with investors taking "higher-than-expected losses."
In the minutes from its Federal Open Market Committee, the central bank said several of the FOMC members were concerned about "the high level of debt in the nonfinancial business sector."
Many fixed-income investors have been focused in recent years on duration risk: As the Fed began to raise rates and send bond prices down, investors fled from longer-dated bonds. Credit-quality concerns, meanwhile, were centered on areas of the bond market known to be more risky, such as high-yield and emerging markets. But the Fed noted that the credit quality of nonfinancial high-yield corporate bonds has been roughly stable over the past several years, as ratings among investment-grade corporate bonds has deteriorated.
"So even if a severe economic downturn does not appear to be on the horizon, investors need to be aware of credit risks associated with their investment-grade bond ETFs, in addition to duration risk," said Neena Mishra, director of ETF research at Zacks Investment Research. She said that while the economy is growing at a healthy pace, as of now, and risks of a recession in the near term appear to be low, the surge in issuance of bonds rated BBB has become a serious concern. In the event of a downturn in the economy, we could see a wave of downgrades to junk status from the lowest investment grade.
The composition among ETFs "looks worse" for intermediate-term investment-grade bond ETFs, such as Vanguard's VCIT and the $5.5 billion iShares Intermediate-Term Corporate Bond ETF (IGIB), which have about 54 percent of their portfolio invested in BBB/Baa rated bonds, making them most vulnerable in the event of even some of these bonds falling to high-yield status.
"These ETFs would have to dispose of those fallen angels, further exacerbating the price decline and leading to a lot of volatility," Mishra said.
The Fed noted in its report that in an economic downturn, "widespread downgrades of these bonds to speculative-grade ratings could induce some investors to sell them rapidly, because, for example, they face restrictions on holding bonds with ratings below investment grade. Such sales could increase the liquidity and price pressures in this segment of the corporate bond market."
But the central bank also stated, "With interest rates low by historical standards, debt service costs are at the lower ends of their historical ranges, particularly for risky firms, and corporate credit performance remains generally favorable."
Lyons at CreditSights doesn't see systematic risk to investment-grade bonds right now, though she remains concerned and stressed that the issues go beyond any single stock that has made headlines for deterioration in credit quality, such as GE or Pacific Gas & Electric. "The amount of debt is getting bigger and bigger, while the ability to trade is diminishing. We are getting more cautious," she said.
A BlackRock spokeswoman said to the extent that there are downgrades from BBB to high yield, those bonds would be gradually removed from the fund, and the risk to investors is potential credit losses associated with BBB downgrades as they are sold from the fund overtime. But she noted that LQD holds over 1,900 bonds, 390 distinct issuers and a 3 percent issuer cap, so it is well diversified.
Vanguard could not provide a comment by press time.
Lyons said CreditSights is not presently of the belief that the cracks in the BBB bond class are widespread, but there will be specific sectors represented within it where more stress should be expected. "I'm not that worried about a massive wave of downgrades," she said.
What could change that view, however, is if ratings agencies decide to react by changing the terms for investment-grade ratings. "They've given companies a lot more leeway," she said, and widespread downgrades could occur if the ratings agencies decide to become more stringent. It has happened before, and recently, with the energy sector being downgraded in early 2016 by the rating agencies. Though Lyons added, "I'm not seeing anything breaking the fundamentals of corporates. They are slowing, but not to the point where I am worried about defaults. It comes back to the agencies and slowing growth and how they react to it."