Be careful about BBB downgrade mania Be careful about BBB downgrade mania http://www.federatedinvestors.com/static/images/fed-logo-amp.png http://www.federatedinvestors.com/daf\images\insights\article\bbb-rating-small.jpg July 22 2019 July 9 2019

Be careful about BBB downgrade mania

Only 0.1% of investment-grade companies defaulted in the last 35 years.
Published July 9 2019
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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.

Tags Fixed Income . Interest Rates . Active Management .
DISCLOSURES

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Bloomberg Barclays U.S. Aggregate Bond Index: An unmanaged index composed of securities from the Bloomberg Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index and the Asset-Backed Securities Index. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indices are rebalanced monthly by market capitalization. Indexes are unmanaged and investments cannot be made in an index.

Bloomberg Barclays U.S. Credit Bond Index is composed of all publicly issued, fixed-rate, nonconvertible, investment-grade corporate debt. Issues are rated at least Baa by Moody's Investors Service or BBB by Standard & Poor's, if unrated by Moody's. Collateralized Mortgage Obligations (CMOs) are not included. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indexes are unmanaged and investments cannot be made in an index.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Credit ratings of A or better are considered to be high credit quality; credit ratings of BBB are good credit quality and the lowest category of investment grade; credit ratings BB and below are lower-rated securities ("junk bonds"); and credit ratings of CCC or below have high default risk.

Russell 3000® Index: Measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market. Investments cannot be made directly in an index.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risk and may be more volatile than investment-grade securities. For example, their prices are more volatile, economic downturns and financial setbacks may affect their prices more negatively, and their trading market may be more limited.

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