Think you're safe buying an investment grade bond for your client? Guess again. Rating downgrades are coming at a record pace.

By increasing client asset allocation into bonds, brokers may not necessarily be reducing risk, even when restricting purchases to quality issues. As Standard & Poor's reports, investment grade bonds are deteriorating into junk status in numbers never before seen.

Year-to-date through Aug. 12, the amount of debt downgraded below “BBB-” this year exceeded $100 billion, involving 50 issuers. This indicates the year-end figures will far exceed the record set last year, when $112 billion worth of debt from 57 issuers descended into junk status.

With economic recovery apparently on the ropes, the near-term outlook is not bright. In fact, S&P reported that global defaults continued their own record-setting pace during the first half of 2002, with 150 issuers missing payments on $85 billion worth of debt. In 2001, 216 issuers defaulted on $117.1 billion — three times greater than the previous record set in 2000.

Diane Vazza, managing director of S&P's global fixed income research in New York, recently reported that the record-setting pace in which investment grade bonds are declining into junk debt is expected to continue for the rest of the year. Industries with the cloudiest outlook include aerospace and defense, brokerage firms, capital goods, and media and entertainment. More than 40 percent of issuers within these industries have a negative outlook.

Better Next Year?

Conversely, the rating of only $35.4 billion of debt issued by 24 firms has been upgraded from junk status since the beginning of the year. The ratio between downgrades and upgrades is at a record high, according to Jack Malvey, chief global fixed-income strategist at Lehman Brothers. But he expects the balance to improve somewhat in 2003.

From a historical perspective, Malvey says the current ratio of junk to investment grade bonds isn't exceptional. “It has fluctuated between 10 and 15 percent over the past decade,” he says, “and has been exaggerated by two basic trends: the dearth of new investment-grade issuances of late and the increasing accessibility of lower credit quality companies to the debt market, which has been going on for quite some time.”

Beginning in the 1980s and then taking off after the recession of 1990-1991, corporate debt financing has been steadily moving away from banks and toward the commercial paper and public bond markets. Today, 80 percent of corporate debt is financed by the latter two facilities.

The rapidly expanding public debt market was driven in large measure by a shift in corporate finance strategy. The new thinking embraced leveraged share buybacks and acquisitions, which also defended cash-rich companies from hostile takeovers. But the expansion of the bond market also enabled marginal companies, which may not have qualified for bank loans, to issue debt as well.

Meeting this demand, the supply of capital expanded as money managers, mutual funds and insurance companies became more aggressive lenders, attracted by the higher yields they could obtain. William Cunningham, director of credit strategy at J.P. Morgan Chase, says, “there was an explosion in risk tolerance as alternative lenders were willing to finance firms that may have been below banks' radar screens.”

However, there was a fundamental problem. While maturities were 10 years and longer, these institutional investors retained focus on short-term performance. By the end of 1999, when interest rates and yield spreads began rising and equity markets started collapsing, many marginal companies found it difficult to refinance. And the prolonged economic slump contributed to increasing volatility of debt markets.

Cunningham believes that the rating agencies missed the mark on two accounts. First, like many analysts, they got caught up with the exuberance of the New Economy model. And second, they failed to recognize the disconnect that was happening between long-term funding needs of many companies and the debt market's increasing reluctance to offer additional financing because of deteriorating near-term outlooks.

However, John Butler, head of debt strategy at Dresdner Kleinwort Wasserstein in London, believes rating agencies were struggling with an even greater problem. “The unusually large number of companies that have been experiencing multiple downgrades over the last three years,” posits Butler, “highlights one of the great illusions created by the agencies — that ratings reflect corporate solvency across the entire economic cycle. They clearly do not.”

Moreover, Butler points to the late 1990s and early 2000s when debt had begun trading increasingly like an undifferentiated asset class. “Investment grade bonds began behaving just like junk bonds,” says Butler, “with prices as volatile as equities, regardless of rating.”

While the debt market has since regained a bit more rationality, the sudden explosion in yield spreads in late July again revealed the market's susceptibility to panic and irrationality, as prices weakened across the board. However, by the end of August, these premiums had receded.

Because he no longer believes ratings by themselves provide the necessary risk diversification, Butler embraces an industry and company-specific approach in structuring a debt portfolio.

Echoing a similar sentiment, Lehman's Malvey thinks rating agencies, despite professing commitment to fundamental analysis, are in fact converging increasingly toward a short-term equity style rating system. “While this enables ratings to be issued in a more timely fashion,” says Malvey, “it also leads to greater ratings volatility.”

Despite increasing confusion about what agency reviews may be telling us, J.P. Morgan's Cunningham relies on buy and sell filters that are based on credit ratings. “Above all,” he cautions, “know the company.” Then, he says consider only bonds that have gone at least one year without a major downgrade of two notches or more, are rated no less than a BBB+ and have stable outlooks. Further, pick companies with stable or improving earnings.

On the sell side, he urges investors to sell the moment a company receives a negative outlook. With the debt market being institutionally driven, major players are clearly well aware of these subtle agency changes as soon as they occur.

“Because institutional investors often tend to accept more risk,” says Cunningham, “they are often willing to stay with a bond despite negative sentiments. By getting out immediately, the individual investor may occasionally leave money on the table. But when investing in debt, the goal is not hitting a home run, but avoiding the blowup.”