Recall: The lowest quality segment of the US investment grade market – BBB-rated bonds – grew 62% between 2014 and 20181 and now represents 51.7% of the index2. Expansion is in part due to debt-funded M&A deals. Raised expectations for a turn in the US economic cycle have fueled concerns about the potential for broad-based downgrades of BBB-rated issuers to high yield, which could in turn challenge returns for investment grade investors and weigh on the high yield market.
Recap: Last November we outlined our take on BBB-rated bonds. In short, we noted that a portion of this rating cohort bears monitoring but cautioned that a single narrative does not reflect the entire BBB-rated market. Our expectation for the elongated US expansion to continue also led us to assign low probability to a wave of downgrades to high yield.
Routine Review: The New Year is traditionally a time to make changes to routines. But for our credit research analysts and portfolio managers, the day-to-day routine is unchanged. The former continue to conduct deep fundamental analysis to strength conviction in their views, while the latter seek to ensure our portfolios are resilient to default losses in order to maximize risk-adjusted returns. A prime example of this in practice is our early-2019 review of BBB-rated bonds. We focused on issuers that comprise more than 0.25% of the US investment grade index, have engaged in M&A, or both. We also reviewed A-rated issuers that we expect to be downgraded to BBB or have participated in M&A deals.
This analysis reinforced our prior assessment; a “one-size-fits-all” mind-set cannot be applied to BBB-rated bonds. From a top-down perspective, expectations for a turn in the cycle (this is not our base case) should not be accompanied by expectations for a broad-based pick-up in downgrade activity. Revenue growth for a large proportion of BBB-rated issuers is not highly correlated to GDP growth. Put another way, these issuers are not especially cyclical. However, sector and issuer selection is important (this consideration is not unique to this rating group). A large proportion of BBB-rated issuers have flexibility to preserve credit metrics and mitigate downgrade risks through asset sales, lower dividend payments or reduced capital expenditure. But for a subset of issuers, we are alert to profit margin pressures (as wage and input costs rise), secular challenges (for Auto and Retail issuers) or litigation risks and costs.
In conclusion: A combination of our call for the expansion to continue and issuer-level analysis leads us to expect downgrade activity to remain muted (Exhibit 1). Even if we were to encounter a downturn we do not see signs that suggest it would be as deep as the global financial crisis when downgrades for US investment grade index on a last twelve month basis reached a peak of 6.2% at the end April 2009.
Source: Based on Bloomberg Barclays US Aggregate Corporate Index (face amounts). As of December 31, 2018.
* Fallen angel: An issuer whose credit rating is downgraded from investment grade into high yield.