BBB corporate bonds provide opportunities for growth and strong risk-adjusted yield without adding the burden of a compromised capital structure.
Given bond ratings’ remarkable importance in securities markets today, the economics team at Payden & Rygel, manager of GSFM’s Payden Global Income Opportunities Fund, sat down to look at important changes in one segment of the US investment grade corporate bond market: BBBs.
They didn’t know it at the time, but when bond issuers and investors emerged from the year 1900, their world would be irrevocably changed. The fast and loose, often local bank-driven, corporate financing markets of the post-Civil War era gave way to the first ever fearsome and stalwart corporate bond rating agency (it was Moody’s; see Did You Know? box)[1]
Today, bond rating agencies dominate investment policy statements, supplier contracts, and real estate leases. According to US Securities and Exchange Commission (SEC) data, in 2016, Nationally Recognised Statistical Rating Organisations collectively maintained 2,334,600 outstanding credit ratings. The big three—Moody’s, S&P and Fitch—alone accounted for 97% of those.[2]
Given bond ratings’ remarkable importance in securities markets today, we sat down to look at important changes in one segment of the US investment grade corporate bond market: BBBs. The BBB (“triple B,” or Baa in the case of Moody’s, and BBB again for Fitch) designation rings familiar in the ear of bond investors as the last rating category which qualifies an issuer as “investment grade”.
To understand the importance and dynamics of the BBB segment of the investment grade corporate bond market, we review recent changes, discuss the evolution of corporate fundamentals within the BBB rating category, evaluate the consequences of downgrades from investment grade to high yield, and suggest what investors can do in the face of these elements to earn satisfactory, risk-adjusted returns.
BBBs now represent almost half of the US investment grade corporate bond market
The reason we mention BBBs now is because much ink has been spilled lately on the topic. And rightly so: BBBs now make up 48% of the investment grade corporate market, up from 42% five years ago and 35% ten years ago (see Figure 1). On their own as an “asset class” BBBs are bigger than the entire high yield and municipal bond market.
This increase over time has generally been viewed as a harbinger of defaults and downgrades by the sophisticated and the layperson alike. Indeed, given the $6 trillion size of the investment grade corporate market, downgrades precipitated by a downturn would likely be weighty.
While on its face, a higher percentage of BBBs implies more “risk”, we want to take a moment to explore both the upsides and downsides of the morphing corporate landscape.
Downgrades and increased leverage have shifted universe composition
The proliferation of lower rated credits has more to it than just “more risk”. For one, it has come from a more stringent view of credits. In the wake of the crisis, spooked rating agencies tightened standards and downgraded banks en masse. By 2010 over half of banks had been downgraded; nearly a quarter had been moved down by at least three notches (the pesky “+” and “-” represent a notch within the category rating). The trend is not just happening post-crisis: In the last 25 years, 20% of single-A or better rated names have been downgraded annually to BBB or below. Only 15% of names have moved in the opposite direction.
BBB issuance has simultaneously picked up meaningfully, making up about half of issuance during the last five years.
In these later days of the ever-lengthening credit cycle, corporate gross leverage (excluding cash that could be used to reduce debt) stands at 2.8x, up from current cycle lows of 2.0x. Leverage among BBBs has risen even more, now at 3.3x, 1.2x higher in the same period. This is reason for pause as the cycle heads into its tenth year (see Figure 2).
Capital structure optimisation may also demand additional leverage
Are the negative headlines overblown? There are oft-forgotten benefits of an expanded BBB universe. Every company has an ideal corporate structure that likely includes debt, and which could reflect a BBB rating. After all, BBBs only pay about 1.5x what single-As pay above Treasuries (a yield premium of about 0.5% currently).
This is especially true in a world of increased private equity and shareholder activism. Activists are looking to squeeze value and boost growth wherever possible and have proven time and again that their opinion carries weight even with behemoth companies.
In the same vein, many corporations now engaging in M&A are expanding their debt purposely, as the growth opportunities afforded by debt are ostensibly more valuable than their current single-A rating.
In a twist of irony, this has made event-prone single-A rated names riskier than BBB names focused on maintaining their capital structures.
Companies are aware of the value of investment grade ratings
Moreover, the cost of the drop from investment grade to high yield is steep. This is not lost on corporate treasurers. For one, it changes how their business is operated. Bank relations shift as unsecured lines of credit become more tenuous. Similarly, terms of trade change as customers and suppliers negotiate with high yield counterparties.
Access to capital markets declines for recently-fallen high yield issuers, too. Investor guidelines play a key role here, as many institutional investors restrict their high yield exposure to a certain percent of their portfolio. The smaller buyer base and much higher premium required by the high yield market looms large, keeping debt levels at bay once they near the BBB- precipice.
Looking at 25 years of downgrade data, 9% of BBB- names annually migrated up a notch to BBB while only 5% fell to high yield, showing at least a modest force of will in practice. (In fact, the upgrade/downgrade difference for BBB- companies is greater than for other A and BBB ratings categories.) This was also exemplified after the 2015-16 commodity crisis when energy companies (well, those that survived!) actively paid down debt to remain investment grade. In a time of crisis, their focus was on bondholders and their creditworthiness (see Figure 3).
Risk is risk: some downgrades to high yield are inevitable
Positive sentiment and a Treasurer’s will alone cannot overcome an overburdened balance sheet. Teva Pharmaceutical is a perfect example of an issuer that failed in its attempt to stay investment grade. Teva acquired competitor Allergan’s generic drug business for over $40 billion in 2016, heavily leveraging their balance sheet just as generic pharmaceuticals started to falter. With such headwinds, Teva ultimately was downgraded to high yield. As its ratings slipped over the last two years, the value of its bonds has fallen meaningfully. It is stories like this that make investors wary.
It comes down to credit selection
Rating agencies aside, it is ultimately careful analysis that remains crucial to bond investing. From an investor’s perspective, there is now a disparate menu of BBB options from which to construct a portfolio. But not all BBBs are created equal: leverage can span from less than 1x to more than 5x for BBB names. This wide array of securities allows portfolios to be carefully crafted with desired risk metrics that align with the investor’s objective and outlook.
As demonstrated in the review conducted above, understanding credit’s topography and avoiding landmines requires a broad knowledge of the corporate market, expertise in industry trends, and in-depth company specific credit analysis. For example, in recent years leverage has increased, but aggregate corporate metrics lack nuance. In the entire investment grade corporate universe in 2016, J.P. Morgan calculated overall debt at ~3.1x EBITDA, but only ~2.8x EBITDA for the universe excluding commodity, metals, and mining companies.
More important are the idiosyncrasies underlying every credit story. We continue to believe wisely selected BBB corporate bonds provide opportunities for growth and strong risk-adjusted yield without adding the burden of a compromised capital structure. And we think the ghost of John Moody would agree.
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