Investors need to be more selective these days when looking at lower-rated investment-grade bonds, according to Wells Fargo Investment Institute. The firm is specifically talking about BBB-rated corporates, which once enjoyed a lot of attention as their credit quality moved closer to that of their A-rated peers. That meant investors were able to pick up higher yields but not necessarily sacrifice much in quality. For the past few years, the BBB-rated assets have had strong interest coverage ratios, which is used to determine companies’ ability to pay interest on their outstanding debts. That has now come to an end, said Wells Fargo taxable analyst Eric Jasso in a note Monday. As debt financed at ultra-low interest rates during the pandemic comes due, companies have to refinance at higher rates. Now, investors need to “exercise caution,” he said. “BBB-rated corporate credit has seen interest coverage materially below long-term averages across almost every sector,” Jasso noted. “This has come despite strong earnings growth in 2024 as the pace at which interest expense has risen [and] has stripped away the healthy cushion seen in interest coverage over the past few years.” LQDB YTD mountain iShares BBB Rated Corporate Bond ETF Investment-grade corporate credit is rated AAA through BBB- by Standard & Poor’s , while Moody’s rates it Aaa through Baa3. As the credit quality goes down, yields rise to compensate investors for risk. The iShares BBB Rated Corporate Bond ETF (LQDB) has a 30-day SEC yield of 5.33%, while the iShares Aaa-A Rated Corporate Bond ETF (QLTA) has a 4.94% 30-day SEC yield. Both have a 0.15% expense ratio. QLTA YTD mountain iShares Aaa – A Rated Corporate Bond ETF Most investment-grade companies have typically been disciplined about maintaining credit quality by reining in generous shareholder reward programs and capital investments when necessary, Jasso said. However, there is a risk some issuers may see longer-term credit pressures as capital intensity increases and profitability decreases — particularly among cyclical industries exposed to the changing trade and regulatory environment, he said. “Given expected macroeconomic headwinds, pressured metrics, and rich valuations among BBB-rated issuers, we recommend investors exercise selectivity when investing in lower-rated investment-grade credit,” Jasso said. Those cyclical sectors affected by trade policy uncertainty include automotive, industrials and consumer discretionary, he said. While the valuations may appear cheaper than other investment-grade sectors, investors should be cautious, he said. Jasso favors issuers within the financial, telecommunications and health-care sectors that have healthy balance sheets, a track record of managing past economic cycles, and are relatively insulated from the back and forth on tariffs.
