And this couldn’t come at a worse time.
Conventional investing wisdom says owning bonds will protect your portfolio when the market drops.
And the market has certainly been dropping. The S&P 500 is down 9% since October.
I would bet that many folks have shifted money out of stocks and into bonds over the last two months.
Much of that money has flowed into investment-grade corporate bonds.
These bonds are traditionally seen as some of the safest bonds investors can buy.
But investment-grade doesn’t mean what it used to.
Corporate Bond Quality Is Plunging
These bonds are rated by credit agencies like Moody’s, S&P, and Fitch. A bond is considered investment-grade if it’s rated between AAA and BBB-.
The closer to triple-A, the safer the bond.
But according to Morgan Stanley, the US has been flooded with BBB-rated bonds.
In just the last 10 years, the triple-B bond market has exploded from $686 billion to $2.5 trillion—an all-time high.
To put that in perspective, 50% of the investment-grade bond market now sits on the lowest rung of the quality ladder.
And there’s a reason BBB-rated debt is so plentiful.
It All Comes Back to Incentives…
Companies have been binging on cheap credit for years.
Ultra-low interest rates have seduced companies to pile into the bond market.
Corporate debt has surged to heights not seen since the Global Financial Crisis:
Source: Wall Street Journal
Higher interest rates make investment-grade corporate bonds less attractive. This is especially true for the lower tiers such as BBB-rated bonds.
That’s how the bond market works. Bonds sold today with a higher interest rate make yesterday’s lower-rate bonds lose value. So, higher-rate bonds are a better deal for investors.
And that’s bad news for the companies issuing these bonds.
BBB-Rated Bonds Have a Target on Their Backs…
In a recession, BBB-rated bonds are the most vulnerable of all investment-grade bonds.
According to Moody’s, 10% of BBB-rated corporate bonds become what’s known in the industry as “fallen angels” in a recession.
That’s a tactful way of saying they’ve been downgraded to “junk” status.
Since the number of BBB-rated bonds has exploded, we will see more fallen angels than ever before during the next recession.
And when that happens, investors that own a basket of bonds in an index fund are going to get hurt.
When Index Investing Goes Wrong…
When a bond’s rating is slashed from investment-grade to junk, it gets automatically kicked out of any investment-grade indexes.
We’re about to see this happen with General Electric (GE). The struggling company is rated BBB+ by S&P—just two notches above junk status.
The stock keeps hitting new lows, and I expect to see General Electric get downgraded to junk in 2019.
If we see a wave of corporate downgrades, corporate bond funds holding near-junk-level bonds will get crushed as they’re forced to sell at bargain-basement prices.
Hit “Sell” if These ETFs Are in Your Portfolio…
My goal is to find the safest yields for my readers. Whether it’s dividend-paying stocks, business development companies, or even gold stocks, I want my readers buying the safest investments possible.
Today, investment-grade corporate bond ETFs are anything but safe.
Of the major investment-grade corporate bond funds, the Vanguard Intermediate-Term Corporate Bond ETF (VCIT) is the riskiest to own.
This $18-billion fund yields 3.6% but has a dangerous mix of assets.
VCIT has 65% of its assets in bonds rated BBB or lower. If we see a big spike in downgrades to investment-grade bonds, this fund will get hit hard.
Next in line is the Invesco BulletShares 2022 Corporate Bond ETF (BSCM).
Even worse, the fund holds three bonds of soon-to-be-junk General Electric.
Lastly, we have FlexShares Credit-Scored US Corporate Bond ETF (SKOR).
This small fund yields 2.9% and has $100 million in assets. But 64% of the ETF’s assets are in bonds rated BBB or lower.
As interest rates rise, I think we’ll see a wave of bond downgrades, and these funds will take the brunt of the downturn.
Now is the time to sell these funds before it’s too late.