An extended period of benign funding conditions has changed corporate bond markets globally. This column shows how the investment grade segment has become dominated by the lowest-rated (BBB) issuers, and these issuers have become more leveraged over time. Given the large stock of BBB-rated bonds, even relatively low transition rates – downgrades from investment grade to non-investment grade – would result in new supply that may be difficult for the non-investment grade market to absorb. In a context of restrictive monetary policy and quantitative tightening, this may have broader ramifications for market stability.
The global corporate bond market is a very different animal today than it was 15 years ago. More than a decade of unconventional monetary policy and a regulatory overhaul in the wake of the 2008 financial crisis, coupled with macro trends like geographical shifts in economic gravity, have resulted in an entirely new market landscape. Given the role corporate debt plays in financial crises, these developments are of significant policy relevance (Ivashina et al. 2024). Recent OECD research in the Global Debt Report 2024 illustrates these changes and considers the potential implications for market functioning and financial stability as the conditions that played a part in enabling them are no longer present.
A riskier market has emerged…
The most visible development is the growth in indebtedness. Total outstanding corporate bond debt stood at $33.6 trillion globally at the end of 2023, up from $21 trillion in 2008. Most of the increase comes from non-financial companies. But the story is multifaceted and not just one of growth. Corporate bond markets have also changed in character, both on the issuer and investor sides of the market. A notable change is the structural decrease in credit quality. In 2021, the global average credit rating for non-financial company bonds had fallen from an average corresponding to A- in the 1980s to just above BBB-, the lowest investment grade rating. In part, this is driven by the expansion of the non-investment grade segment, which has grown faster than the broader market. But the more striking development has taken place within the traditionally safer investment grade segment.
Today’s investment grade market – where default risks are lower and where risk-averse investors are more active – is significantly riskier than it has been historically. It has become dominated by the lowest-rated companies, with BBB bonds now making up more than half of global non-financial corporate bond issuance, up from less than a third in the early 2000s (Figure 1, Panel A). At the same time, the BBB category has itself become riskier, with BBB- bonds (the lowest BBB category rating) making up an increasing share of issuance. In addition, these ratings now describe a more leveraged issuer than they previously did. The median leverage (measured as debt-to-EBITDA) of a BBB issuer was more than a third higher in 2023 than in 2008 (Figure 1, Panel B). In 2023, 42% of all BBB bonds were issued by a company with a debt-to-EBITDA ratio above four.
Figure 1 The characteristics of the investment grade market have changed
Notes: Refers to non-financial companies, three-year rolling averages. In Panel B, leverage is measured as debt-to-EBITDA, winsorised at 1%. Negative-value observations are excluded.
Source: OECD (2024), Global Debt Report 2024, Chapter 2: Corporate debt markets in a changing macrofinancial landscape.
…dominated by new investors
In parallel, the ownership landscape has changed. The most notable development is the increased prevalence of investment funds. In the US, the world’s largest bond market, investment funds increased their ownership share of the non-financial market from 8% in 2008 to 34% in 2021 (before dropping to 23% in 2022). But the expansion of investment funds is a global phenomenon. To illustrate this, we construct a dataset of a universe of open-ended fixed income investment funds (OEFs) with at least 1% net exposure to corporate bonds and study how it has developed over time. The net number of new such funds (fund creations minus fund destructions) has been positive in every year since 2000, resulting in a total of over 15,000 funds at the end of 2023 (Figure 2, Panel A). Of these, 6% were exchange-traded funds (ETFs), compared to less than 0.5% in 2008, illustrating the rapid growth of this investment vehicle.
Investment funds have not just increased in number, they have also become more heavily exposed to corporate bonds. In 2023, the average net exposure to corporate bonds by open-ended funds was over 50% (Figure 2, Panel B). For ETFs it was as high as 64%.
Figure 2 Investment funds have become key players in corporate bond markets
Note: Refers to fixed income funds with at least 1% net exposure (long exposure minus short exposure, measured as a share of the total portfolio) to corporate bonds (latest available observation). Excludes closed-end funds and money market funds. Dead funds can be either liquidated or merged into another fund.
Source: OECD (2024), Global Debt Report 2024, Chapter 2: Corporate debt markets in a changing macrofinancial landscape.
In part, this development is an intended effect of the post-2008 reform of the global financial regulatory framework to de-risk the banking sector and diversify credit supply. The increased capital requirements for banks attached to holding inventories of corporate bonds associated with the Basel III reform has migrated bond holdings to the non-bank financial sector. But it is also an effect of central banks’ quantitative easing (QE) programmes. As part of efforts to stabilise financial markets and to get inflation up to target, central banks amassed substantial holdings of corporate and, above all, sovereign bonds. At the end of 2023, the central banks of the US, euro area, Japan, and the UK held approximately 30% of the aggregate stock of sovereign bonds issued by their governments.
This has kept yields structurally low and encouraged investors to seek returns in higher-risk instruments, including corporate bonds. Evidence suggests that funds which weigh their portfolio towards higher yielding (higher risk) bonds generate higher inflows, especially during periods of expansionary monetary policy (Choi and Kronlund 2018). Such behaviour tends to intensify price volatility (Fricke and Barbu 2021).
Possible implications and dynamics around the investment grade threshold
These two developments – a concentration of increasingly indebted BBB-rated issuers in the investment grade segment and an increased prevalence of investment funds as owners – combine in a way that may have implications for market stability in a context of tighter monetary policy. The withdrawal of a major market player through quantitative tightening and continued elevated sovereign borrowing needs mean significant amounts of government debt need to be absorbed by investors other than central banks. With sovereign securities now offering more attractive yields than in previous years, this raises the question of what the consequences will be for the corporate bond market. This is especially pertinent given the extent to which this market has become dominated by more price-sensitive investors.
In addition to the refinancing risks of the broader market, there are also specific considerations for bonds around the investment grade threshold which merit attention given the increase in such debt in recent years. To look at how these bonds interact with the change in ownership structure, we identify a sample of 1,161 fixed income funds that are specifically categorised as investment grade funds, with a total size of $3.2 trillion. Like other investment funds, these funds (including ETFs) have increased their exposure to corporate bonds in recent years (Figure 3, Panel A). This is illustrative of an overall riskier investment profile. But of particular interest is their exposure to bonds just above investment grade. In early 2024, investment grade funds’ net exposure to BBB rated securities represented over a fifth of their total portfolio, equivalent to more than $650 billion (Figure 3, Panel B).
This portfolio structure, together with the investment grade fund label, make these funds particularly exposed to fire sale risks, beyond the regular exposure stemming from the liquidity mismatch between fund shares and underlying assets. In a scenario where a significant share of triple B bonds are downgraded, investment grade funds may need to sell substantial amounts into illiquid secondary markets. Even if this happens over an extended period, it could have a large impact, with possible broader ramifications for market functioning and stability.
It is ambiguous whether this risk differs between ‘traditional’ open-ended funds and ETFs. While some research suggests that the structure of bond ETFs allows them to absorb liquidity pressures and counteract fire sale dynamics (Shim and Todorov 2021), there are also indications that ETFs tend to worsen liquidity conditions in periods of stress (Koont et al. 2022).
Figure 3 A fifth of investment grade fund portfolios’ net exposure is to BBB-rated securities
Note: Based on 1,161 different funds where the Morningstar Institutional Category includes an indication of ‘investment grade’ or a specific investment grade rating, such as ‘BBB rated’ and ‘A rated’. Only fixed income funds with at least 1% net exposure to corporate bonds (measured as a share of the total portfolio) are considered. The data refer to all rated holdings, including sovereign securities.
Source: OECD (2024), Global Debt Report 2024, Chapter 2: Corporate debt markets in a changing macrofinancial landscape.
What is the probability that there are meaningful downgrades from investment grade to non-investment grade (‘fallen angels’)? Historically, bonds rated BBB- have the lowest probability of being downgraded of all ratings. Part of the reason is that issuers focus their efforts on maintaining creditworthiness when they reach BBB-, given the impact on the cost of capital of having an investment grade rating, which goes beyond that of a regular credit rating up/downgrade (Jaramillo and Tejada 2011). The fact that BB+ rated bonds are most likely to be upgraded is illustrative of the same dynamics (Çelik et al. 2020). However, that does not mean that triple B bonds are never downgraded. In 2009, following the global crisis, 7.5% of the stock of BBB rated bonds transitioned to a non-investment grade rating. Annual historical average transition rates are around 5%.
To gauge the capacity of the non-investment grade market to absorb new supply, we look at different hypothetical transition rates and calculate what share of actual five-year average annual non-investment grade issuance they would correspond to. Given the significant current stock of BBB rated bonds, even a relatively modest transition rate of 5% would represent new non-investment grade supply equivalent to almost three-fifths of average annual issuance (Figure 4). That begs the question of whether the non-investment grade segment would be able to absorb this without substantial impacts on yields and therefore default risks. The level of potential systemic contagion these scenarios would have depends on the behaviour of the holders of the downgraded debt and the portfolio overlaps between investors (Schaanning et al. 2020).
Figure 4 An increase in fallen angels may be difficult for the non-investment grade market to absorb
Note: Refers to non-financial companies.
Source: Chapter 2 in OECD (2024).
We believe this merits consideration, especially given that these issuers have reached record levels of leverage in recent years. That was sustainable under the very favourable financing conditions of recent years but might not be at significantly higher borrowing costs. Even as major central banks around the world now seem to be moving towards rate cuts rather than further tightening, it is important to note that most of the monetary policy tightening since 2022 has not yet fully transmitted to the corporate sector. Both investment grade and non-investment grade bonds are overwhelmingly issued with fixed interest rate structures, and the average maturity is as long as eight years, even for non-investment grade bonds. Consequently, refinancing at current interest rates, or even slightly lower, would still mean markedly higher debt servicing costs than at present.
The process of quantitative tightening will likely add additional pressures, particularly for BBB rated issuers. Research suggests that companies just above the investment grade threshold have benefitted disproportionately from subsidised financing costs during quantitative easing (Acharya et al. 2022). As that process reverses, there is reason to suspect that default rates may hit these issuers the hardest.
Source : VOXeu
