Market Views: Fixed Income
Why fears over the rise in triple-B corporate bonds look overdone
While the rise in triple-B corporate bonds over the past decade has been substantial, it seems it is only now starting to attract significant attention from the media. As this issue has come into focus so too has consideration of what this means for the overall quality of the corporate bond market and its future prospects.
There is no doubt that a major shift has taken place over the decade since the credit crisis, which has seen the triple-B group within the US corporate bond index increase from about 35% to 50% of the index.
At first glance, concern is understandable. Triple-B is the lowest quality credit rating still classified as investment grade (IG).
When the business cycle turns and economic conditions become more adverse, triple-B bonds can quickly be downgraded to double-B. These become known as “fallen angels” since this represents a downgrade from IG to high yield (HY) and tends to come with a large price tag for investors (whose bonds lose value) and borrowers (who will have to pay higher rates to borrow in future).
The magnitude of this change within the IG corporate bond market is sizable. So too is the potential impact should we see a sharp rise in the number of fallen angels in the next downturn. But, overall, we think concerns are likely somewhat overblown, for a number of reasons. Much of the growth in triple-B has come from banking and energy, both of which have undertaken significant measures to strengthen their balance sheets and operate with greater discipline. Another significant source of triple-B growth has been more defensive sectors with stable earnings, such as healthcare and the food and beverage sectors. Lastly, triple-B now includes a more significant contingent of large multi-national companies, many of which could take steps to try and prevent a downgrade if needed.
The rise of the triple-B and fallen angel risk
The most obvious concern is that the sheer size of the group has reached an unprecedented level. Today, at 50% of the US corporate bond index, triple-Bs amount to about $2.5 trillion of debt. In 2008, the group accounted for about $670 billion of debt, or 33% of the index. Therefore, triple-Bs have become a much larger piece of a much larger US IG debt pie, driven by historically low borrowing costs, among other things.
On top of this growth in size, the average leverage (a company’s ratio of debt to EBITDA or earnings before interest, taxes, depreciation and amortization) of triple-B issuers has risen steadily from a post-crisis low of about 2x in 2011 to about 2.5x today. This compares to about 1.75x average leverage for single-A rated companies (one rating notch above BBB). This increase in leverage is an indication that the percentage of fallen angels could ultimately be high relative to previous recessions.
There is also reason to think that the cost of owning fallen angels will be relatively high in the coming downgrade cycle. Firstly, foreign investors, particularly in Asia, have been a strong source of demand in the US corporate bond market (see chart below). As a group, they tend to be sensitive to ratings and would likely be quick to sell any issuers downgraded to high yield, resulting in significant spread and price volatility. Additionally, there has been a large rise in passive IG bond products. These too would become forced sellers as the downgraded bonds would fall out of their eligible universe.
Also, the HY market has become much smaller as net supply has been negative for some time, suggesting any sharp increase in new supply would not be easily absorbed. To illustrate the magnitude of this potential supply flood in HY, the triple-B market is currently 4.6x the size of the double-B market.
Light supply was a key reason US HY remained strong through much of 2018 given the magnitude of outflows, so a large supply shock would be troublesome for the asset class.
Defensive industries are a large component of triple-Bs
To understand the full picture, however, it is important to examine the makeup of the triple-B group and the drivers that contributed to its rapid growth. One of the largest industries in the group (about 11% of triple-Bs), and the one that contributed most to its growth in terms of par value, is banking. Post financial crisis, banks are heavily scrutinised and regulated. As a part of this process, many were downgraded to triple-B subject to their displaying better capital discipline and balance sheet health.
Today, banks are far better capitalised with much healthier balance sheets, suggesting a lower downgrade risk come the end of the business cycle than historically. The overall ratings outlook for banks is currently stable to positive. In fact, the largest US banks have experienced ratings upgrades over the past year.
Another group representing a large portion of triple-Bs (about 12%) and growth over the past decade is energy. Following the oil crisis in 2016, when Brent crude oil hit a trough of $27.5, there was a wave of downgrades. Rating agencies downgraded energy companies aggressively, partly on the view that oil prices would stay depressed. While oil prices have since recovered, energy companies have maintained financial discipline and avoided excess risk taking.
Stripping out banking and energy, two industries that are healthy by historical standards and face relatively limited downgrade risk, triple-Bs represent 38.5% of the total US IG index.
The final group to have contributed most to the growth of triple-Bs are non-cyclicals like consumer staples, communications and healthcare.
These are considered defensive industries due to their ability to maintain earnings stability in economic downturns, and with that are less likely to experience the severe deterioration in credit metrics that precedes downgrades to HY.
A final point is that the average triple-B issuer is much larger today than historically. This is, in part, due to the fact that the banks, energy and consumer non-cyclical companies are more likely to be large multi-national corporations with very large capital structures. While this is often cited as a concern, we consider it a positive as large multi-national corporations are incentivised to maintain IG status for a range of reasons beyond cheaper yields. IG companies have much easier access to short term capital while avoiding more expensive revolving credit facilities, while HY borrowers are subject to much stricter conditions to protect investors. Large IG corporations also tend to have greater scope to prevent ratings downgrades through asset sales or capital expenditure reductions. These issuers will not become fallen angels without a fight.
Let them triple-B
We acknowledge that the increase in triple-B bonds is important to monitor, especially as the risk of recession or a downturn rise. Schroders’ philosophy of conducting fundamental credit research on a company-by-company basis will be as important as ever as downgrade risk tends to rise on an idiosyncratic basis. Ultimately, however, we think concerns are somewhat overblown given that so much of this growth has been in healthy industries which tend to have relatively little earnings volatility.
The average company in the triple-B bucket is much larger than before, suggesting they are businesses with strong incentives to retain IG status and that they should have the ability to do so. Considering the consensus view that a recession is at least a few quarters away, there is still time for triple-B issuers to reduce leverage, particularly since downgrades typically lag the economy and market. Overall, it will be key to evaluate the progress of deleveraging moving forward and to keep a close eye on the further evolution of triple-Bs. But for now, we will let them triple-B.