Yellen and the Fed are afraid of a corporate debt bubble, but investors still aren't

Key Points
  • Former Fed Chair Janet Yellen was the latest high-profile person to express concern over corporate debt.
  • In an appearance Tuesday in New York, Yellen said problems in the area could exacerbate another downturn.
  • Conversely, Bank of America Merrill Lynch said lower-rated corporate debt remains a solid investment.
  • Leveraged loans, another potential problem spot, are one of the best-performing parts of the market this year.
US dollar bill notes
Francis Dean | Corbis | Getty Images

The corporate debt scaring policy experts like former Fed Chair Janet Yellen isn't throwing too much of a fright into market participants.

In fact, some of them are continuing to load up on lower-grade corporate debt because it's managed to be a better performer than some of the investments considered to be safer.

"Offense is the best defense," Hans Mikkelsen, credit strategist at Bank of America Merrill Lynch, told clients in a note pointing out that BBB-rated companies are outperforming their A-rated counterparts. BBB is the last rung before junk, and the increasing level of company bonds going to that level is causing concern.

Some investors worry that the companies whose debt is in danger of slipping into high-yield territory will have trouble meeting their obligations during the next economic downturn.

Why the US market is this investor's biggest concern
Why the US market is this investor's biggest concern

But Mikkelsen thinks those concerns are misplaced.

The S&P 500 Triple-B investment-grade corporate bond index is down 2.9 percent year to date, which is not good. However, the group is outperforming the broader S&P 500/MarketAxess Investment Grade Corporate Bond Index, which is off 3.5 percent in 2018.

The outperformance grows when isolating for risk-adjusted excess returns and runs counter to history when credit spreads are widening. Higher-quality bonds usually outperform in those cases, Mikkelsen noted.

"This outperformance of BBBs is noteworthy as one of [the] key investor concerns this year remains the possibility that large BBB-rated capital structures get downgraded to high yield during the next downturn," Mikkelsen wrote. "We think this outperformance reflects in part a low recession probability being priced into credit spreads, as well as the fact that most large BBBs are unlikely to get downgraded to [high-yield] anytime soon as they tend to have stable cash flows and significant financial flexibility."

One of the reasons he cited for the unexpected outperformance was that the "US economy is strong and credit fundamentals are improving" while negative technical signals are sprouting up elsewhere.

Merrill Lynch recommends investors use BBB debt as part of a "barbell" portfolio, combined with Treasurys, as counterweights to safe but underperforming A-rated debt.

Yellen sees 'lots of bankruptcies'

Yellen, though, warned Monday that companies are taking on too much debt and could be in trouble should some unexpected trouble hit the economy or markets.

"Corporate indebtedness is now quite high and I think it's a danger that if there's something else that causes a downturn, that high levels of corporate leverage could prolong the downturn and lead to lots of bankruptcies in the non-financial corporate sector," the former central bank leader said during an event at CUNY in New York.

Yellen also warned that the debt is being held in instruments similar to ones used to bundle subprime mortgages that led to the financial crisis a decade ago.

Indeed, corporate debt has been swelling.

The investment-grade part of the bond market stood at $3.8 trillion at the end of October, a 6 percent rise from the same period a year ago, according to Fitch Ratings. BBB-rated bonds accounted for 58 percent of that total, up from 55 percent in 2017.

At the same time, though, bond defaults actually are expected to decline.

Moody's Investors Service forecasts that default levels on corporate debt will decline in 2019 to 2.3 percent from 3.2 percent this year.

"Our positive outlook for North American non-financial companies reflects meaningful, albeit decelerating, GDP growth in US and G-20 countries in 2019, and robust growth in emerging markets," said Bill Wolfe, Moody's senior vice president. "Good liquidity and low refinancing risk support a declining default rate, and exposure to gradually rising interest rates will generally be manageable."

In addition to Yellen's warnings, current Fed officials also recently noted that leveraged loans, which are issued to already indebted companies, pose a significant risk.

But that part of the market has been performing extraordinarily well this year.

The Markit iBoxx USD Leveraged Loans index has returned 1.98 percent year to date, while the Liquid Leveraged Loan Index is up 1.2 percent.

Average bid prices from banks issuing the loans also has risen, up 3.37 percent for the U.S. and 15.4 percent in Asia.

By way of comparison, the S&P 500 is down more than 1 percent and the Bloomberg Barclays US Aggregate Bond index has seen a total return loss of 1.8 percent.

Outflows are rising

None of that is to suggest that investors should get overly sanguine about bonds, and recent behavior shows that money has been leaving the space.

Investment-grade bond funds have seen outflows in 11 of the past 12 weeks, to the tune of $3.8 billion in investor cash, according to BofAML, a total that amounts to just 0.1 percent of the total market. High-yield funds have seen outflows for eight of the past nine weeks, amounting to $1.9 billion or 0.15 percent of the total outstanding.

Despite its reduced outlook for defaults, Moody's cautioned that "highly leveraged issuers" are "potentially vulnerable as monetary tightening unfolds." The ratings agency also said that the "risk of downgrade or default is highest for low-rated companies that rely on third-party financing and which need immediate market access."

However, Moody's also pointed out that only about 5 percent of companies considered speculative grade are considered to have weak liquidity and thus are in elevated danger.