You Might Be Invested in the Most Expensive Parts of the Corporate-Bond Market

One useful lens here is not whether “corporate bonds” are expensive in the abstract, but how much of a portfolio’s credit exposure sits in the market’s lowest investment-grade tier. BBB-rated debt can look like a small detail in a broad bond fund, yet it often carries a meaningful share of the sector’s valuation and recession sensitivity. That makes composition, not just headline category labels, the key issue for long-term investors.

For ETF and fund investors, the practical question is concentration. Two funds with similar corporate-bond mandates can behave very differently if one has more BBB exposure, longer duration, or tighter spread sensitivity. Investors comparing broad core bond options should look past the category name and examine how much of the portfolio is tied to lower-quality issuers that may be more vulnerable if credit conditions deteriorate.

This also matters for diversification inside a larger asset allocation. Multiple holdings can create the illusion of spreading risk while still leaving a common exposure to the same segment of the credit market. If several funds in a portfolio lean heavily on BBB corporates, the aggregate exposure may be larger than expected even when each holding seems reasonable on its own.

The main portfolio takeaway is to review, not react. Rich valuations in one part of the bond market do not automatically mean investors should abandon it, but they do justify checking whether the role of corporate credit is balanced against Treasuries, other high-quality bonds, and the investor’s tolerance for spread widening. Rebalancing and fund overlap analysis can be more useful than making a binary call on one sector.

Asset managers’ expectations for the economy are all over the place, but most aren’t predicting the worst. The bond market, however, expects the Federal Reserve to cut its short-term federal-funds rate, which it usually does to avoid the risk of a recession. At the end of February 2024, bond futures prices implied expectations that the Fed will cut its federal-funds policy rate to 4.5% by the end of 2024 from its then level of 5.5%.

A vertical bar chart showing the highest expected federal-funds rate after each future meeting of the Federal Reserve Open Markets Committee to determine the rate. — Source: CME FedWatch Tool, 100 basis points = 1%. Highest expected federal-funds rate as implied by 30-day federal-funds futures pricing data.

There’s a long-term shift in a corner of the bond market that could prove even more sensitive if we do wind up in a recession, though. Although corporate bonds overall are close to their long-term average weightings in the Morningstar US Core Bond Index, concentration in the sector’s BBB rated debt (the lowest rung of the investment-grade ladder) of 51% was close to its all-time high at the end of January 2024. Meanwhile, the extra yield that this market segment generates compared with US Treasuries has been lower only a couple of times over the past decade. In other words, the index has been more heavily exposed to the lowest-quality investment-grade corporates at a time when those bonds are historically around their most expensive, and therefore at greater risk of losing money if their yields simply move closer to average.

Trying to predict when a particular slice of the corporate-bond market will underperform is exceedingly difficult. And it’s possible that BBB valuations could stay rich for some time, especially if the Fed manages to pull off the elusive goal of a soft landing for the economy. Slipping into a recession, however, would likely cause pain for the economically sensitive lower tiers of the investment-grade corporate-bond universe, such as BBB rated issues. That’s not a prediction of doom—especially since trouble, in this case, could mean underperforming Treasuries at a time that yields overall are still coming down—but rather a caution that allocations to those bonds could lag more than they might have during earlier periods of economic weakness.

BBB Heavy Funds

Against that backdrop, we looked at funds with the largest exposures to BBB rated debt in the Morningstar FundInvestor 500 that are also heavily invested in corporate bonds.

There is a little good news in that many of those offerings performed within close range of their Morningstar Category averages during the 2020 coronavirus selloff, the most recent severe test of their mettle. A few of the largest funds that performed well versus their categories included Vanguard Intermediate-Term Investment Grade VFIDX, Vanguard Global Wellesley Income VGYAX, and BlackRock Systematic Multi-Strategy BAMBX.

Of course, that’s no guarantee they will perform the same way in a future crisis, but the results of such comparisons are usually indicative of a fund’s temperament.

By contrast, a handful of other Morningstar FundInvestor 500 funds heavily weighted in BBB rated debt underperformed their category averages during the coronavirus selloff, including Vanguard Long-Term Corporate Bond Index VLTCX, Loomis Sayles Investment Grade Bond LIGRX, and Loomis Sayles Strategic Income NEFZX.

None of that is meant to serve as advice to dump your funds if they have large BBB concentrations. If one or more constitute a large share of your portfolio, or if a handful of funds do, it would be worth looking to see if you have a large collective exposure to those issues. If you do, consider whether you have as much diversification as you would like.

https://www.morningstar.com/bonds/are-you-invested-most-expensive-parts-corporate-bond-market

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You Might Be Invested in the Most Expensive Parts of the Corporate-Bond Market

Futures Markets Expectations for the Federal-Funds Interest Rate

Yield Spread of BBB Rated Corporate Bonds and Percentage Weighting in the Morningstar US Corporate Bond Index

BBB Heavy Funds

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