In the second half of 2018, the increase in BBB debt became a thing. “Look at how BBB debt makes up almost half of the corporate index now” became a thing to worry about. It suited the narrative around wider credit spreads, weaker equity markets, higher US rates; a self-fulfilling prophecy of debt-filled doom. Except that this isn’t anything new: what we see today has been the case for a number of years.

Share of BBB-rated bonds in major investment grade indices


Source:iBoxx as at 31 December 2018

It’s worth having a think about why there’s more debt. There are lots of answers to this question, but there is one very obvious explanation: Debt is cheap. By way of an example, back in 2016 BBB-rated British American Tobacco issued 35-year debt with a 2.25% coupon (tax deductible for BAT), while at the time the dividend yield on BAT shares was 3%…

For government debt markets, cheap funding costs are not whole the story. Whilst corporates may get downgraded because they choose to have more debt, governments tend to get downgraded because they, well, have to have more debt. No need to go into the politics of the doubling of the UK’s debt pile over the last 10 years, but the mix of Keynesian economics supporting an otherwise weak economy along with the desire for social cohesion has meant the UK government needed more debt funding. In the process the UK lost its AAA rating; Moody’s cut the UK to AA1 in 2013 and to AA2 in 2017. Same for Japan, AA2 back in 2011 and now A1 rated; and it was S&P that took the knife to the America’s credit rating in 2011 taking it to AA+. Only 58% of the Bloomberg Barclays government bond index is AAA and AA today, down from 94% at the start of 2009. When looking at government bond markets, the ratings sag of the world’s governments is just as pronounced as in corporate bonds.

As home owners in the UK and elsewhere know, it is not the nominal amount of debt that matters (per se), but instead the ability to service that debt. As government debt has ballooned over the last 10 years, gilt funding costs have significantly decreased, supported by zero interest rate policies, quantitative easing and the low/non-inflationary environment. Better rated corporates whose funding costs are “spread” to governments (like the aforementioned BAT) have thus benefited too, along with less well-rated credits as investors hunted for yield.

There should be no “shame” for corporates rated weaker A or high BBB. Academic and market wisdom has it that in these rating areas companies have the “right” balance between debt and equity and can achieve the best cost of capital. That is less clear cut for governments.

For investors, the concerns over weaker corporate ratings should also be concerns of weaker government bonds market ratings. Numbers in isolation only tell part of the story, but an increase in BBB debt provides opportunities for active managers. Too much debt drags on both corporate and government balance sheets alike. Whilst the two are inextricably linked, the solutions are potentially very different. Companies (that are able) can either trade their way out of debt or sell assets. Governments, on the other hand, can either hike taxes (typically politically tricky) or hope for some inflation; those that have their own currency can always print money.

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