Fallen Angels
Interest rates are low, and debt is cheap. So companies with good credit ratings have made the rational move and borrowed as much as humanly possible, driving corporate debt-to-GDP to near all-time highs. The Federal Reserve’s “extend and pretend” approach to forestalling defaults since ’08 has added fuel to this fire.
A recent chart from the Wall Street Journal shows this sharp rise in BBB corporate bonds. The graph shows more muted growth in speculative-grade bond issuance, but this is the result of a massive expansion of the private credit market rather than any conservativism on the part of speculative-grade borrowers.
Figure 1: Corporate Debt Levels
This increase in BBB credit has some commentators worried. What if a recession comes and there is a massive wave of downgrades into high yield? Will there be enough buyers for all the fallen angels?
Our friend Jim Liew at Johns Hopkins thinks not. “We can predict with near certainty that when the next downturn occurs, much like the Asian crisis, there will be no buyers of the underlying corporate bond securities that are being packaged into ETFs and mutual funds,” he and colleagues wrote in a recent paper provocatively titled “This Time Is Different, but It Will End the Same Way: Unrecognized Secular Changes in the Bond Market since the 2008 Crisis That May Precipitate the Next Crisis.”
Are the authors’ concerns merited? And what should investors do to prepare if they are? We address three of their major arguments below.
The authors are right that BBBs will be downgraded in the next recession, though they’re wrong on the magnitude.
The table below shows what happened to BBB bonds that went through the 2001 and 2008 downturns. This shows the worst rating over the subsequent three-year period for all bonds rated BBB at the end of 2000 and 2006. At year end 2000, 27% BBBs fell to high yield, and at year end 2006, 17% of BBBs fell to high yield.
Figure 2: BBB Bond Downgrades in the Past Two Recessions
Source: Verdad. Issuer weighted, US issuers only.
Notably, only 3–5% of BBB issuers reached the CCC and below level where the bonds are highly likely to be impaired, and indeed there were a handful of bankruptcies. The vast majority of bonds remained BBB or BB. But much of the criticism aimed at the BBB market today is that it is both lower quality and larger than in the past. Below, we show the credit stats for BBBs at the end of the last two expansions and today.
Figure 3: BBB Credit Stats
Source: Verdad. US issuers only.
These credit metrics are higher than 2006, but look quite similar to 2000. These are not scary numbers: 3.0x leverage and 4x enterprise value to debt are not metrics associated with companies that enter distress. And we do not see fundamental credit risks to BBBs in excess of historical averages based on this debt.
We agree with the authors about the change in ownership base and the number of forced sellers, but we see this more as a wealth shift from some investors to others rather than a threat to the economy.
As the authors point out, a lot of mutual funds and ETFs and institutions with mandates to hold investment-grade bonds become forced sellers when there’s a downgrade. This is partially why BBs have historically been the best performing subsector of the high-yield market—they receive more than half of the fallen angels that investors are forced to sell. The chart below shows the annual returns of fallen angels versus original issue high-yield bonds.
Figure 4: Fallen Angels Have Higher Returns
Source: Verdad.
Any downgrade wave would be a great boon to high-yield investors. These fallen angels are about the best investment opportunity high-yield investors get.
The authors are right about the dynamics of the BBB marketplace, but wrong about this being a systemic risk.
Systemic risks require default waves, and that’s very unlikely in these BBBs. Rather, this will be a simple transfer of capital from investment-grade corporate bond investors to high-yield corporate bond investors, with one side making forced sales below intrinsic value and the other side buying bargains on firms that yield more than they should.
Where we agree completely with the authors is their concern about the growth of private credit and CLOs. What is most interesting about the Wall Street Journal chart above is what is missing. Where is the growth in speculative-grade debt? The answer is that it is in the private markets. As a recent Forbes article points out, from 2007 to 2019, high-yield bonds outstanding grew 112%, but leveraged loans grew 191%.
The true risk to the economy isn’t in liquid, well understood, BBB-rated securities but in the CLO liabilities, leveraged loans, and private credit, especially those on the wrong side of the fool’s yield where solvency is the concern. Private credit is mostly owned by private funds, BDCs, or structured vehicles. There are many potential buyers for bonds, but private credit is not an easily accessible market, and it is very difficult for new buyers to emerge. Indeed, the most likely scenario is that the private equity firms who issued much of the debt will be the ones raising funds to buy it when it goes bad.