August 19, 2019
The amount of debt in BBB-rated bonds – the lowest rung of investment grade categories – has risen substantially in recent years, now comprising 51% of the investment grade universe, up from 33% in 2010 (sources: Bloomberg and Macquarie Investment Management). This development has captured investors’ attention recently, sparking fears that the growing number of BBB-rated companies, vulnerable to economic stress, could potentially lead to widespread downgrades to the high yield, or “junk,” bucket.
Growth of the US BBB market
Sources: Bloomberg and Macquarie Investment Management, as of Dec. 31, 2018. CAGR denotes compound annual growth rate.
Despite these concerns, we favor being overweight in BBB-rated credit, believing that valuations in this ratings category are more attractive than higher-quality A-rated debt, perhaps due to these broad downgrade fears. As we discuss below, the BBB-rated part of the credit market is large and diverse, which we believe provides potential opportunities to invest in resilient credit stories that could reward investors through strong fundamental credit research and careful security selection, even during periods of economic stress.
We see several market factors that argue for remaining solidly invested in the BBB-rated credit portion of the investment grade market:
- The BBB category’s relatively wide rating disparities offer a spectrum to choose from. These include differences in potential downgrade rates between a bond rated BBB+ and one that is BBB-, which can help serve as a rating “cushion.”
- Highly levered bonds with a mid-BBB or BBB- rating most often have less room to avoid downgrades. But disciplined capital management by these issuers to adhere to deleveraging plans could incentivize these issuers to remain investment grade, whereas A-rated issuers may be more willing to take on leverage and sacrifice their ratings while still remaining investment grade.
- The level of corporate leverage in the overall BBB-rated market has stabilized in our view, providing attractive valuations for careful selection of companies that are following deleveraging plans.
Below we explore these factors in more detail.
A rating “cushion” in BBB
The disparity of credit quality across the full BBB-rated market is notable. Approximately 75% of the BBB-rated market is either mid-BBB or BBB+, with only a small portion (25%) rated the riskier BBB-, the last rung on the investment grade ladder before falling to high yield (source: Bloomberg). We think it’s worth noting that three-quarters of the BBB market (BBB+ and BBB), which the press has written so much about recently, has one to two rating notches of cushion before being considered a “fallen angel.” (Fallen angels are issues designated as high yield that have dropped from investment grade through some form of credit degradation.) As the chart below shows, the mid-BBB and BBB+ categories combined have increased in recent years (as a percentage of the overall BBB ratings category), effectively expanding this relative ratings cushion to high yield, with the BBB- segment holding relatively steady and slightly shrinking since 2015 (sources: Bloomberg and Macquarie Investment Management).
The BBB market by ratings category
Sources: Bloomberg and Macquarie Investment Management, as of Dec. 31, 2018.
From risk profiles to mispricing, there’s more to BBBs
Furthermore, credit rating agency Standard & Poor’s has expressed the view that many nonfinancial BBB companies tend to have defensive business models, which can help protect them during untoward events, such as a slowdown in sales or profitability. This can allow the credit rating agency more leeway from having to downgrade BBB issuers upon an unexpected economic slowdown. In fact, in a recent report by Standard & Poor’s on the business risk profiles of US nonfinancial corporate BBB-rated issuers, a combined 41% were found to have either excellent or strong profiles, and 51% were satisfactory (source: S&P Global Ratings, 2018, including private rated companies).
In our own research, we also focus heavily on company fundamentals – gauging how these companies might withstand factors including economic softening, higher labor costs, and trade war effects, to name just a few. Depending on the company’s business profile, credit metrics, and valuations, we may find good cause to select a BBB-rated issue. Also, due to investor sentiment, the BBB part of the US credit market may become over- or under-valued relative to BB-rated and A-rated issues. The chart of relative spreads below shows that BBBs appear relatively undervalued compared with higher A-rated issues, which could be an opportunity for astute investors.
Historical ratio of BBB/A spreads
Sources: Bloomberg and Macquarie Investment Management, as of June 30, 2019.
Higher ratings don’t necessarily mean safer
We see another important consideration at the lower end of the investment grade market, in that moving up in credit quality may not necessarily insulate investors from future losses due to ratings downgrades. Companies that are A-rated typically are larger and better capitalized than lower-rated peers – characteristics that could be seen as dry powder for shareholder-friendly activities, which could cause a ratings downgrade (while still maintaining a lower-investment-grade rating). Such events could lead to unexpected volatility in A-rated issues which often times are deemed “safer” by investors, simply due to a higher credit rating than that of a BBB-rated issue.
In a world of low interest rates (that is, low corporate borrowing costs), A-rated companies may be incentivized to reward shareholders and sacrifice their A-ratings. In some cases, this can make A-rated issuers that get downgraded to BBB a surprise to investors, in our view. In the graphic below, we show examples of A-rated companies that were downgraded, and the resulting effects before and after the downgrades.
Effects of downgrading from A to BBB
Sources: Standard & Poor’s and Macquarie Investment Management.
Note: “A” index refers to the A-rated component of the Bloomberg Barclays US Corporate Investment Grade Index. Table shown is for illustrative purposes only.
Being aware of the risks – and the opportunities
Source: Bloomberg. EBITDA margin refers to the assessment of a firm’s operating profitability, equal to earnings before interest, tax, depreciation, and amortization (EBITDA), divided by total revenue.
As seen in the charts above, leverage has elevated in both the BBB-rated and A-rated parts of the market. However, we believe that many corporations have sufficient profitability and free cash flow to provide adequate financial flexibility to address their leverage issues for the present, assuming current credit and economic conditions continue. As risk-aware investors in this shifting market environment, we believe it’s important to look past the headlines surrounding the BBB-rated market, and identify securities in this category that potentially offer more opportunity than even higher rated ones – but with research-based, careful credit selection as the key.
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