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Rising investment-grade debt sales may threaten the financial system's stability, the New York Fed says

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Key Points
  • A large volume of bonds issued with a "BAA credit rating may pose a financial stability concern," the New York Fed said.
  • Sales of bonds from companies at the bottom tier of investment grade ratings have equaled or exceeded issuances of high-yield corporate debt for the last three years.
  • The growing difference in market size between AAA and BAA bonds make the credit spread between the two a poor indicator of how investor's view debt, the Fed said.
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Rising corporate debt sales and changes in the market makeup for investment-grade bonds may pose risks to financial stability, the New York Federal Reserve said Wednesday.

Sales of investment-grade bonds have grown in recent years, leaving highly-rated companies with debt levels that appear as risky or even riskier than lower-rated companies, the New York Fed said on its blog, Liberty Street Economics.

Only two U.S. companies are rated AAA, Microsoft and Johnson & Johnson, while companies from a broad swath of industries are rated at BAA from Moody's or BBB from Standard & Poor's, which are the bottom tier of investment grade. In its post, the Fed referred to both groups as BAA.

Issuances of BAA debt have equaled or outpaced new sales of riskier high-yield debt every quarter since the fourth quarter of 2016, according to the Fed.

"Although much of the post-crisis issuance has been in the investment-grade segment of the market, the large volume of issuance with a BAA credit rating may pose a financial stability concern," the Fed said.

The large amount of debt at at the bottom tier of investment grade means a wave of bond downgrades could threaten financial stability, the Fed said. Downgrades can lead to additional selling pressure as bond holders like insurance companies move to offload lower-rated debt.

A big gap in the sales of bonds with AAA and BAA ratings could also reduce the effectiveness of a recession indicator, the Fed said. The credit spread between the two classes of debt has historically widened around recessions, making it an indicator of the health of the economy.

Because there are only two companies rated AAA, the flood of new BAA debt creates a situation where the yields on the BAA bonds reflect investor views on a wide variety of factors, while the AAA yields are based mainly on information from two companies.

These differences make the yields AAA and BAA debt "noncomparable," the Fed said.

"Not only are the issuers of AAA bonds no longer comparable to the issuers of BAA bonds, but the average maturity of BAA bonds is far greater than the average maturity of AAA bonds, with the disparity in maturity growing over time," the Fed said.