Be careful about BBB downgrade mania
Which headline grabs more eyeballs: “Corporate debt bomb bubbling” or “Corporations quietly reduce leverage and increase interest-rate coverage”? Need we even have asked? But while mid-tier investment-grade BBB corporate debt certainly has risen in recent years, commentators’ assault on its soundness in times of market stress and the dire consequence of downgrades are misleading, all but equating downgrade with default.
As only a step above high yield, it is easy to cast aspersions on BBB-rated debt. But a rating downgrade, say from A- to BBB+, usually will only slightly pinch a company’s financial picture, and very few downgrades actually lead to default. In fact, Moody’s recently found that only 0.1% of investment-grade companies defaulted in the last 35 years. Further, its data from 1970-2018 show it was nearly twice as likely that a low BBB-rated company upgraded to mid-BBB than fell to high BB.
But more to the point, much of the rise of BBB-rated debt comes from sound business practice of leveraging when needed and paying down that debt after it has helped companies grow the business. This is happening now. While BBB-rated debt within the Bloomberg Barclays Credit Index (a popular measure of the U.S. investment-grade bond market) grew from 31.5% to 46.8% between 1999 and 2018, that trend is reversing. BBB-rated debt fell to 46.28% of the credit index year-to-date as of March 31, 2019. Probably more important, the stock of newly issued BBB-rated debt is falling, according to Barclays research. For those sentimental about the “good old days,” at 3.4 times, this year’s first-quarter BBB leverage was lower than in 1991, 2001 and 2015, and interest-rate coverage—the ability to service that debt—at 9.9 times was higher than any point since 1988 except for 2013-14, (Barclays). Remember, too, that equity is on the chopping block long before contractual interest payments, meaning the doubling of the Russell 3000 index since 2000 provides a strong cushion underneath fixed income.
At the heart of the matter is that ratings are dynamic, and two-sided. Many downgrades are the result of strategic management choices to assume higher leverage for M&A or share repurchases. And many of these businesses, including banks and energy companies, have seen ratings upgrades as they reduce that leverage. Of course, it isn’t only self-discipline causing the reduction of BBB debt. The slashing of the corporate tax rate from 35% to 21% means that debt costs more and freeing of overseas cash from tax punishment means there is less need for debt issuance in general. In 2018, new issuance fell more than 17% (Barclays).
Contrary to all the cries that BBB-rated debt will cause a recession is that it has performed well during them on a relative basis. In the last five, BBB-rated debt’s performance was in line with or better than the broader, higher-quality Bloomberg Barclays U.S. Aggregate Index that also includes U.S. Treasury and agency securities, and far outperformed the S&P 500. More broadly, over the 25-year period through last year, bonds rated BBB have outperformed all other domestic investment grade sectors, thanks primarily to the higher coupon interest payments that accounted for over 99% of BBB’s average annual return of 6.57% (Barclays) and bonds rated BBB have outperformed all other domestic investment grade sectors.
Bottom line, most successful managements have used BBB-rated debt as a tool to advance their business, not because their companies are in a free fall. They are now reducing leverage because it costs more to have it. The credit cycle is aging, and good management teams want to prepare. Having an experienced credit staff can help you navigate this part of the cycle and what comes next.