by Brad Tank, Chief Investment Officer—Fixed Income, Neuberger Berman
It’s been one of the biggest talking points in credit markets ever since Grant’s Interest Rate Observer published “Attack of the Killer BBBs” in October 2017.
Massive bond issuance at the lowest level of investment grade—half of the U.S. investment grade credit market, almost $3 trillion, is now rated BBB—was fine as long as the cycle extended, the argument went. But when the cycle turns, the subsequent downgrades would overwhelm the high yield market. As recently as April, a noted credit strategist was calling for $1 trillion of downgrades.
Well, the cycle has turned. In fact, the COVID-19 recession is the equivalent of hanging the queen bee around our neck and giving the hive a hearty kick.
So, are we feeling the sting?
Leverage
We’ve taken a good look at this on a number of occasions and were never able to buy into the “Killer BBBs” thesis.
We first published our thoughts in August 2018, and the last time we checked in on the situation was on the eve of the current crisis, seven months ago.
Our take hadn’t changed much. We were wary of the autos sector and our view of its weak secular and cyclical fundamentals. But on the whole, in our view the BBB universe has grown because fundamentally high-quality companies have either been taking advantage of very low long-term financing rates, or funding acquisitions and then using strong free cash flow to pay off the debt.
We noted that the average leverage of the top-10 BBB issuers had been declining, and that the prospect of a sudden, mass downgrade to high yield was unlikely.
Our bear case “L-shaped” scenario on BBBs that had become pervasive may have underestimated the flexibility that issuers have to retain an investment grade rating when they make it a priority. Robust capital availability, evidenced by record new issuance supported by central bank intervention, has been a game changer, as well.
Defaults
Our outlook for earnings and cash flow profiles look very different now, but we are still not overly concerned about BBBs. Although the credit cycle has turned, we believe it will likely be mild relative to what happened in 2008 – 09, or even after the tech bubble.
Back in April, our projections for cumulative defaults through 2020 and 2021 in U.S. high yield and leveraged loans were around 15% and 12%, respectively. Today, however, those estimates are more like 9 – 10% for U.S. high yield and 8 – 9% for leveraged loans. For European high yield we anticipate a 3% default rate, and 7% for global high yield.
It’s a similar story in emerging markets. For corporate high yield issuers we anticipate a default rate of just 4.6% in 2020. That is three times the 2019 rate, but lower than 2009, when the default rate reached 10.5%, and even lower than the 5.1% rate at the end of the commodity super cycle in 2016.
You really have to get to the junkier and micro end of the spectrum of private debt, real estate loans and working capital lines of credit to see the widespread defaults and write-downs we’re reading about from the commercial banks.
Able and Willing
The interventions by governments and especially central banks have been decisive. The Federal Reserve’s inclusion of select “fallen angels” in its corporate credit facility has been a notable factor.
That has likely given credit markets the confidence to remain open, providing companies with a “liquidity bridge” to the other side of this crisis—even during its darkest days. Ultimately, we believe that confidence rests on an understanding that most companies, including those rated BBB, are not perilously over-leveraged and are unlikely to have their credit downgraded all at once.
So far this year $162 billion worth of bonds have been downgraded from investment grade to junk, and while that is a record in dollar terms, it is a long way from $1 trillion and still represents less than 2.5% of the investment grade market. We would expect the pace of downgrades to cool off from now onwards.
The high yield market has been easily able and largely willing to absorb this acceleration of fallen angels. After all, even the exceptions that are both very big and not exactly in the top-tier for quality, such as Kraft Heinz, still tend to be more liquid and more robust than your average BB issuer. In our view, that makes them an attractive source of high risk-adjusted yield.
Honey
Historically, fallen angels have in general underperformed their BBB counterparts during the last months of investment grade rating but then outperformed BBs in the months following their downgrade to junk. This cycle has proven no different, although the extent of the post-downgrade outperformance has been more dramatic. Year-to-date, fallen angels have returned 18.8%, compared to 7% for BBBs and 4.1% for BBs.
There are caveats. Credit selection is important because not every business will make it to the other side of this crisis and the returns of individual credits have been widely dispersed. Approximately 22% of fallen angels have underperformed the ICE Bank of America U.S. Corporate BB Index post-downgrade—offset by a larger proportion that has outperformed by five percentage points or more.
Needless to say, we believe capable credit analysis is required to sort this all out, but during this period, selected fallen angels have been one of the big value-adds in our own credit portfolios.
While some credit investors have been running scared of the “Killer BBBs,” we’ve chosen to stick around and harvest the honey.
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