When it comes to an economic downturn, small companies without an S&P Global Rating could be hit first, according to S&P Global Market Intelligence. A credit rating signals a company’s ability to repay its debt and those without the rating could potentially be in a world of hurt.

“The unrated entities are like the canary in the mine,” said Michelle Cheong, Director at S&P Global Market Intelligence. “They are the ones that usually start to default first — before you see trouble happening among the rated entities—because they are the weaker link.”

Next in line could be companies that are at the lowest rung of investment-grade. At the height of the extended bull market, risky less-than-investment-grade bonds were in vogue with their attractive yields, particularly in a rising rate environment, but BBB bonds that are on the cusp of high yield status could be facing a liquidity crisis, according to a recent CNBC report.

As the volatility seen has been racking the stock markets as of late, it has also affected the bond markets, particularly liquidity–the ability purchase and sell an asset within a reasonable amount of time. BBB bond markets are especially susceptible because institutional investors, who carry war chests full of capital that aid in liquidity, aren’t able to invest in these bonds if they become high yield or “junk” issues.

BBB bonds comprise about half of the investment-grade bond market and a lack of liquidity could leave BBB bond investors holding the debt as it toes the line between investment grade and junk bond status–the worry, of course, being that it may eventually fall into the category of the latter.

In order to avoid a possible liquidity crisis, investors can opt for more liquid exchange-traded funds that allocate capital into investment-grade debt issues like the Xtrackers Investment Grade Bond Interest Rate Hedged ETF (BATS: IGIH) and ProShares Investment Grade—Interest Rate Hedged (BATS: IGHG).

IGIH seeks investment results that track the performance of the Solactive Investment Grade Bond – Interest Rate Hedged Index where a portion IGIH’s total assets will reside in long positions in U.S. dollar-denominated investment-grade corporate bonds. As in the case of IGHG, this strategy effectively eliminates exposure to riskier bonds with fund allocations in investment-grade issues.

IGHG tracks the performance of the Citi Corporate Investment Grade (Treasury Rate-Hedged) Index with long positions in investment grade corporate bonds issued by both U.S. and foreign domiciled companies. This is particularly important during market downturns when the propensity for a company to default on its debt is higher. As such, IGHG focuses on investment-grade issues to reduce credit risk

For more trends in fixed income, visit the Fixed Income Channel.

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