The increasing risk of investment grade indices: implications for investors

Box extracted from special feature "Markets swing on perceptions of the policy outlook"

BIS Quarterly Review  |  September 2022  | 
19 September 2022

Investment-grade (IG) corporate bond indices have grown riskier over timeicon. The share of bonds rated BBB, the lowest rung of the IG segment, has been increasing for the past 30 years. At present, BBB bonds in one of the main US IG indices represent half of the total, up from 25% in 1990 (Graph A, first panel). The increase was mostly at the expense of bonds rated AA and above, whose current share is less than 10%, down from more than 35% 30 years ago. In this box, we explore the drivers of these changes and the implications for investors.

The steady decline in the credit quality of IG indices reflects two broad trends in corporate markets. The first is search for yield in an environment of persistently low interest rates. Bonds rated BBB are particularly attractive to IG-focused investors that seek to earn higher yields, including many mutual funds.icon  The second broad trend is the general increase in issuance by BBB-rated firms, which accelerated with the launch of several central bank asset purchase programmes that further reduced these companies' cost of funding.icon,icon

The declining credit quality of IG indices has translated into a meaningfully higher risk of losses for investors. IG indices tend to be more sensitive to non-diversifiable credit risk than "synthetic" versions of these indices based on the rating composition in 1990 (Graph A, second panel, red bars). A moderate increase (one standard deviation) in credit risk would go hand in hand with an 11 basis points larger drop in current IG indices, as compared with synthetic ones. Given the present size of IG funds, this means that the change in the index's composition since 1990 would translate into an additional loss of $5 billion for investors. The higher risk is also visible in measures of tail risk (5% value-at-risk) and volatility (second panel, blue and red dots).

Understanding the implications of the increased riskiness of IG indices is particularly relevant for small investors. Funds benchmarked to IG indices have increased rapidly over the past decade and manage $4.8 trillion as of 2022 (Graph A, third panel). Investors in these funds are probably attracted by the increased income from riskier IG indices – their yield spread to Treasury bonds is currently 25% higher (35 basis points) than it would have been with 1990 rating shares (fourth panel). At the same time, small investors tend to rely on benchmarks to gauge the risk profile of fundsicon and may not be fully aware that the riskiness of IG funds has increased, despite their unchanged IG label.

icon  The views expressed are those of the authors and do not necessarily reflect the views of the BIS.    icon  B Becker and V Ivashina, "Reaching for yield in the bond market", Journal of Finance, vol 70, no 5, October 2015.    icon  For a recent study on the real economy implications of the demand for risky IG bonds, see V Acharya, R Banerjee, M Crosignani, T Eisert and R Spigt, "Exorbitant privilege? Quantitative easing and the bond market subsidy of prospective fallen angels", BIS Working Papers, no 1002, February 2022.    icon  K Todorov, "Quantify the quantitative easing: impact on bonds and corporate debt issuance", Journal of Financial Economics, vol 135, no 2, 2020.    icon  B Sensoy, "Performance evaluation and self-designated benchmark indexes in the mutual fund industry", Journal of Financial Economics, vol 92, no 1, 2009.