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Corporate bonds at risk of crash on abrupt downgrades

London

SURGING supply of corporate debt in the riskiest investment-grade category leave markets vulnerable to a rout if economic weakness triggers bouts of rating downgrades, according to the Bank for International Settlements.

Investment-grade bonds classed BBB by ratings firms - one step above junk status - have proved popular with funds bound by their own rules to hold only low-risk securities. While central banks pursued cheap money policies in the years after the financial crisis, such bonds offered tempting yields while still falling into the low-risk category that made them eligible holdings.

In 2018, BBB-rated bonds accounted for about 45 per cent of US and European mutual fund portfolios, up from 20 per cent in 2010, according to the BIS. But many investors may have to sell those bonds if they fall out of the investment-grade scale.

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If an economic downturn prompts credit-rating cuts, this could trigger a market crash as investors dump newly ineligible debt from their portfolios, according to the BIS.

"If, on the heels of economic weakness, enough issuers were abruptly downgraded from BBB to junk status, mutual funds and, more broadly, other market participants with investment grade mandates could be forced to offload large amounts of bonds quickly," wrote analysts at the the Basel-based institution in a quarterly report.

"While attractive to investors that seek a targeted risk exposure, rating-based investment mandates can lead to fire sales."

The BIS, known as the central bank for central banks, isn't the first to warn about the dangers associated with so-called fallen angels. Barclays Plc's chief executive officer Jes Staley said in November that regulators should be concerned about the junk-debt market's lack of capacity to "absorb what's sitting above them" once it's downgraded.

Still, Mr Staley's own analysts at Barclays told clients last week that those concerns are "overstated" because the economic outlook remains benign and some companies are on course to receive a credit-rating upgrade.

BlackRock Inc money manager Jeff Cucunato has also dismissed concerns about BBBs being a "big disaster". BIS has previously warned about excesses in lending to leveraged companies, alongside other officials including Bank of England governor Mark Carney.

Still, the premium for holding risky corporate debt has narrowed in 2019 with an "exceptionally strong" performance entirely erasing a selloff in European credit in the fourth quarter of 2018, according to JPMorgan Chase & Co. BLOOMBERG