Ben Edwards, manager of the £917m BlackRock Corporate Bond fund, has maintained his 60% exposure towards BBB-rated bonds despite fears of a downturn that could result in investment grade vehicles falling to 'junk' status.
There have been warnings from fellow bond fund managers and central banks alike that with such a large portion of the investment grade credit market now in BBB bonds - the tier has grown from around 30% of the market to more than 50% in the past decade - a financial shock could see BBB bonds downgraded to non-investment grade or 'junk' status, leading to spiking borrowing costs and a higher risk of defaults.
However, Edwards, who has run the fund since 2011, remains optimistic as he focuses on companies that should avoid being devalued in the case of a downturn.
He said: "The goal of all corporate bond funds is not necessarily to only hold the very best quality but to avoid bonds that transition down from one category to a lower one, or ultimately default.
"One misconception is that lots of debt is bad, but often it is just because the company is big. Companies tend not to run into trouble because they have borrowed too much money but because they have done that and then have high earnings volatility."
Edwards said he focuses on companies with strong visibility and earnings stability, which means the portfolio has a quality
bias, with many positions in insurers and banks. Meanwhile, the manager is still able to take advantage of the attractive risk/reward trade-off that comes with investing in BBB bonds.
He added: "The rationale to own any asset is to be fairly compensated for the risk.
"Right now, the probability of an A-rated bond defaulting over five years is around 0.5%, while for a BBB-rated bond it is around 1.5%.
"The additional yield versus government bonds for the sterling single-A index is 1.33%, while for the BBB index it is 1.94%. "That additional yield should compensate investors for the small incremental risk."
The fund has held 60% of its portfolio in BBB bonds for the last 18 months, over which time it has outperformed both its benchmark, the ICE BofAML Sterling Corporate & Collateralised, which returned 4.8% and the IA Sterling Corporate Bond sector average of 3.6%, having delivered 5.1% from 27 September 2017 to 27 March 2019, according to FE.
But Edwards remains cautious as the size of the US BBB market ($3trn) means the high yield and leveraged loan market (currently about $2.3trn) could get "swamped" in the case of a downturn and resulting downgrades.
He said: "Some BBB-rated companies are operating with much higher leverage than is normal for their rating. If they can use free cashflow to pay this down over the next few years, all is well.
"But if we enter a downturn, they would be at risk of downgrading to junk and bond prices could fall by more than history has ever seen."
Nonetheless, Edwards welcomed the higher level of issuers offering bonds into the market as he believes it offers more choice and a better chance of good quality.