Corporate Debt Concerns Should Prompt Portfolio Review

  

Rising business debt and its potential risks to the economy should prompt pools to take another look at the credit risk in their investment portfolios.

Dan ByrnesDan Byrnes of AAM cites a recent speech by Federal Reserve Chairman Jerome Powell on the possible dangers posed by increasing business debt. While not reaching the level of concern that subprime mortgages posed a dozen years ago, Powell said that “business debt has clearly reached a level that should give businesses and investors reason to pause and reflect.”

Powell went on to say that “if a downturn were to arrive unexpectedly, some firms would face challenges.” He noted that the debt is not only plentiful, it’s riskier debt as well. “Among investment-grade bonds, a near-record fraction is at the lowest rating—a phenomenon known as the ‘triple-B cliff.’ In a downturn, some of these borrowers could be downgraded into high-yield territory,” Powell said. That in turn would require some investors to sell their holdings, as the bonds would no longer be investment grade.

That’s a potential concern for pools that have made corporate bonds the centerpiece of their investment policies. It may translate to greater volatility than they have come to expect when their assets are marked to market, says Byrnes.

He suggests that pools would do well to make sure that their investment policies are set up in a way that the pool is not a “forced seller” of the bonds they hold.

“You want to be thoughtful about how you would approach selling if there’s a downgrade; if you sell immediately following a downgrade you would be selling at one of the weakest points,” he said.

Byrnes notes that in times of stress, it’s not always possible to get an investment committee together to approve holding downgraded securities, and the markets won’t wait for them. The best policies, he says, are those that have language providing a little flexibility, perhaps allowing a small percentage of the portfolio to be downgraded without a forced sale, giving pools time to make a considered decision.

He recommends that pools work with their investment advisers to understand the risk currently in their portfolios and ensure their investment policies “are really well diversified.”

“It’s easier to have these discussions when there’s not a lot of panic out there,” says Byrnes.

Byrnes will deliver a session on bond investments at the Fall Educational Forum, October 6-9 in Cleveland, OH. His firm, AAM, supports AGRiP as a QEI patron.


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