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Trading in bond exchange traded funds (ETFs) spiked during the first quarter of 2020 as market participants assessed the impact of the coronavirus pandemic on the global economy.

Attention is turning to bond rating agencies that evaluate the ability and willingness of corporate issuers to repay debt. Rating agencies in the first quarter issued downgrades to investment grade companies in numerous industries including energy and travel.

Many investors are keeping an eye on “fallen angels,” bonds that were issued with an investment grade rating but were subsequently downgraded to “speculative,” or high yield-rated bonds. Future downgrades will affect the composition of index-tracking ETFs linked to both investment grade and high yield bond markets.

This environment offers two important reminders for ETF investors:

  • Most managers of index-tracking ETFs have a certain amount of discretion when entering and exiting positions. They are not generally required to sell at any specific moment in time following a downgrade.
  • The diversification benefits of broad corporate bond indexes can help defray credit losses tied to specific downgrades, even large ones.

Growth of the BBB bond marketplace

The investment grade bond universe had tripled in size to over $7.5 trillion since the 2008-09 global financial crisis.1 The market grew as companies issued more debt to achieve efficient leverage ratios, pursue shareholder friendly policies and satisfy investor demand for fixed income assets.

As companies issued more bonds, the BBB-rated portion of the investment grade universe—those on the cusp of investment grade and high yield status—grew markedly. Bonds rated BBB constituted about 50% of the investment grade bond market at the end of February.2 Roughly 12% of the investment grade bond universe had the lowest possible rating in the category (BBB-/Baa3). And some 3% of the market had both this lowest rating and was on “watch” by at least one rating agency.3

BBB-rated securities as percentage of the investment grade market

Line graph showing the percentage of BBB-rated securities’ percentage of the overall investment grade market from 1990 to 2018.

Source: ICE BAML and BlackRock as of 3/31/2020.

Fallen angels increase as the credit cycle turns

In March 2020, issuers like Ford Motor Company, Occidental Petroleum and Delta Airlines all were downgraded from investment grade into high yield.

The actual pace of downgrades may change as rating agencies continue to evaluate factors including whether stay-at-home orders across the globe will have temporary or lasting economic impacts, and what low oil prices may mean for numerous industries. In this uncertain environment, bond issuers can defend their credit ratings by cutting dividends, reducing spending and halting share buybacks.

Percentage of Investment grade debt downgraded to high yield

Bar chart showing percentage of investment grade debt downgraded to high yield each year from 2000 to 2019.

Source: J.P. Morgan as of 2/28/2020.

How do bond ETFs manage downgrades?

Investors often think of index-tracking exchange traded fund (ETF) management as a purely rules-based process that involves little human discretion. This view belies the nuance of how index ETF managers may seek to achieve returns of their reference indexes in the service of meeting the fund’s objective.

Notably, index fund managers are not generally required to sell bonds at the exact time that the index changes at month-end. This is because fund prospectuses typically allow for some flexibility to manage around such events. For iShares fixed income ETFs specifically, the portfolio managers can invest up to 10% in out-of-index securities, meaning managers can sell securities before a rebalance or hold them after one if doing so is aligned with the fund's investment strategy.

As a pioneer of the first bond ETF in 2002, iShares has the benefit of relying on the deep-rooted bond-trading acumen of BlackRock with sophisticated portfolio analytics using BlackRock’s proprietary Aladdin® platform.

Downgrades: A sequence of events

Three discrete actions precipitate a fallen angel bond leaving an investment grade bond ETF.

First, one or more rating agencies downgrade a bond or bond issuer. For most index providers, they use multiple inputs from nationally recognized statistical ratings organization (known as rating agencies), such as Moody’s Investor Services, Standard and Poor’s and Fitch Ratings, to determine if a bond is investment grade or high yield. Often if an issuer is rated by more than one rating agency, then issuer would need to be downgraded by two agencies before it is considered high yield.

Second, an index provider announces index composition changes based on the updated ratings and other index inclusion criteria. While many equity indexes usually rebalance once per year or quarter, fixed income indexes rebalance monthly to account for new bond issuance, rating changes (upgrades and downgrades), coupon payments, principal paydowns, and bonds with maturities that cease to fall within a benchmark’s specified range.

Third, a bond ETF portfolio manager reviews the holdings of the fund and makes adjustments to keep the ETF on track with the index. As a reminder: The ETF portfolio manager generally does not need to sell a downgraded bond at the exact moment of an index rebalance.

Case studies: Kraft Heinz and Occidental Petroleum

Market participants often price in the potential for a bond rating downgrade well in advance, sometimes over years. Other times, an exogenous event can adversely impact an issuer’s credit risk. In both scenarios, the credit impact of downgrades on an ETF portfolio may be mitigated by diversification of its holdings, which can be comprised of thousands of bonds.

Bond ETFs are affected by downgrades based on a bond’s weighting in its portfolio, its entry and exit prices, and the timing of the entry and exit.

Take Kraft Heinz Corp. and Occidental Petroleum Corp., two recent fallen angels, as examples of the extent to which downgrades can impact bond ETF performance. Kraft Heinz was downgraded to BB+ (high yield) by Standard & Poor’s and Fitch Ratings on Feb. 14, 2020; a third major ratings firm, Moody’s Investors Service, maintained the issuer at Baa3 (investment grade).

Given that two major ratings agencies considered Kraft to be high yield instead of investment grade, its largest bond, which matures in 2046, was removed from major investment grade bond indexes on Feb. 29.4

Market participants had long demonstrated their concerns about the potential for Kraft Heinz credit deterioration. This was evident in Kraft’s bond prices, which were well below par value at the time of the downgrade.

We estimate that over time, using a simple average price since the bond was issued in July 2016, index-tracking investment grade corporate bond ETFs would have acquired Heinz at a price of about $93.25.

On Feb. 29 2020, the bond was priced at $92.77, or approximately 0.5% below where bond ETFs may have acquired the position. For perspective, Heinz accounted for 0.31% of the ICE BAML US Corporate Bond Index at the time of removal.5 Accordingly, an ETF tracking that index that incrementally acquired this bond from when it was issued would have seen credit-related loss to the portfolio of only around 0.0016% if held in the same weight as the index.

Occidental, an energy producer, exhibited a larger price impact than Kraft Heinz after the price of oil fell 67% in the first quarter of 2020. Occidental was downgraded to Ba1/ BB+ (high yield) by Moody’s, Fitch and Standard & Poor’s on March 18, 20 and 25, respectively. It would have been removed from indexes on March 31 or April 30, depending on the index. Occidental’s weight in the ICE BAML US Corporate Bond Index was 0.22% as of the end of March 2020.6

Due to uncertainty about the oil market, Occidental’s bond price fell from above $100 to $55.83 by the end of March 2020. Given its index weighting at the end of March, we estimate a roughly 0.09% credit-related loss to a broad corporate bond index portfolio, though the impact to an ETF would depend on the price change and the weight of the holding, which can vary depending on the situation.7

Summing it up

ETF investors should expect more downgrades of investment grade bonds in the months ahead although the potential diversification benefits of corporate bond indexes can help insulate investors from credit losses related to any single bond issuer.

As the credit cycle turns, they should know that managers of index-tracking investment grade bond ETFs have certain flexibility to manage each downgrade in striving to meet the fund’s investment objective.

iShares corporate bond ETFs can rely on the expertise of BlackRock’s bond trading desk to help ensure efficient executions.

Chris Dieterich
ETF Strategist and Commentator
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