Over half of corporate debt today is rated “BBB,” making it the largest swath of the investment-grade market, whereas 20 years ago it accounted for less than one-third of investment-grade bonds. Investors must carefully navigate this vast territory to both home in on rising stars and avoid deteriorating “fallen angels” that might get downgraded or even go into default. Once a company drops out of investment-grade territory, Persons says, it’s a long, hard climb to get back in because rating agencies can be slow to recognize improvement.
Persons leans on a large staff of bond analysts to identify companies climbing the quality ladder. He also consults with MFS equity analysts to get a full picture of companies’ financial profiles and how bonds fit into them. “I prefer ‘BB’ companies where the stock price is improving to those with declining prices. I’ve found that a rising stock price is often a leading indicator for an improved rating.”
The fund spreads its bets widely among 279 holdings. One holding is Ball Corporation, a manufacturer of food and beverage containers and a company that Persons believes has a better financial profile than its rating suggests. The company is in a “consistently stable” industry and has strong cash flow, but its bonds have only a “BB+” rating, even though more highly leveraged beverage companies are in investment-grade territory. “I’m not sure why agencies have a more generous threshold for leverage for beverage companies than container companies,” Persons says. “They are very similar industries. I think the agencies have it wrong here.”
Persons also thinks MSCI, another “BB+” issuer, is an up-and-comer. The company has low capital requirements, stable cash flows from its analytics and index businesses, and minimal debt.
Fund holding Verisign, a domain name registrar, also has ample free cash flow to service debt, a consistent business and an equity stash that far outweighs its debt burden.
As far as sectors are concerned, Persons is not enthusiastic about consumer staples companies because he believes many of them have sacrificed growth to pay out the steady dividends they are known for. Changing consumer tastes, some ill-advised mergers and acquisitions, and increasing leverage are all making the sector a less defensive play than it used to be. He’s also wary of pharmaceutical companies because of government intervention and price controls in that industry. Instead, he favors health-care supply companies, which are positioned to take advantage of the aging population’s needs for products that require regular replacement for day-to-day caregiving.
The Cloud of Corporate Debt
The corporate bond market’s strong performance at the beginning of 2019 is unlikely to be repeated the rest of the year, Persons says. The MFS fund was up over 6% in the first four months alone.
Still, a lot of the elements are in place for a decent second half. The Federal Reserve seems happy to let interest rate hikes take a breather, at least for now. And while the stimulus of U.S. tax cuts seems to have run its course, expectations for modest growth and benign inflation bode well for corporate bonds. The outlook for U.S. investment-grade credit is favorable, and strong investor demand provides a tailwind.
One potential cloud on the horizon is the enormous amount of corporate debt floating around. According to the Fed, the dollar value of corporate bonds (excluding banks) outstanding in the U.S. grew from $2.2 trillion in 2008 to $5.7 trillion at the end of 2018. The bulk of this growth occurred in the investment-grade sector. Within that group, the most notable increase was in the “BBB” category, which more than tripled in value from approximately $0.8 trillion in 2008 to $2.7 trillion by the end of 2018. A substantial portion of the rise in corporate debt was used to fund share buybacks, dividends and merger activity.