The TEXPERS Blog

Is the BBB credit bubble ready to burst?

Photo:iStock/Brian A Jackson

By Garry Creed, Guest Columnist

The size of outstanding BBB-rated corporate debt has exploded in recent years, nearly quadrupling since the 2000s. A booming BBB market has investors asking two key questions: Will these companies be able to maintain their investment grade status as the cycle turns and if not, what will be the impact on credit markets as they transition to high yield?

Will these companies be able to maintain investment grade status?

Our baseline view is credit will continue to benefit from a steadily growing U.S. economy over the near-to-intermediate term. Longer term, we believe we’ll see downgrades consistent with past economic cycles.

When the cycle turns, we expect downgrade activity from investment grade to high yield, commonly referred to as fallen angels, which will likely be consistent with past downturns in percentage terms. To assess the potential size of the next fallen angel wave, we applied Moody's historical rating migration percentages to the current BBB market value of $2.4 trillion as of Q2 2018. Assuming an average rate of 11% for the ten worst downgrade years, the next downgrade wave could exceed $250 billion if the severity mirrors prior years (Exhibit 1).

Exhibit 1: Potential magnitude of future fallen angel activity

Top 10 largest historical BBB to high yield downgrade rates applied to current BBB market size

Click chart to view larger image.

^{Source: Aegon AM US, Bloomberg Barclays and Moody's. Reflects top 10 largest ratings transition years from BBB to high yield ratings based on data from Moody's from 1970 – 2017. Applies historical downgrade percentages to BBB market size as of June 30, 2018.}

What will be the impact on credit markets as BBB-rated companies transition to high yield?

First, a weakening credit environment is likely to increase the risk premium required by investors to hold investment grade bonds as they begin to price in the risk of downgrades. Second, the transition from investment grade to high yield may cause dislocation in the high yield market.

Continuing with our earlier example, $250 billion of migration in a year is roughly equivalent to 20% of the aggregate high yield market and approximately equal to the average annual gross high yield issuance over the past ten years through August 2018. Contrary to most new high yield issuance, downgrades typically aren't price sensitive. They happen regardless of market conditions or investor demand and prices adjust to facilitate the needed transitions. Furthermore, fallen angels tend to rise when the high yield market is also facing fundamental pressures from weakening credit conditions. When considering this, and overlaying the scale of downgrades in our high yield market example, one can see why it is likely that the rise in fallen angel activity could have a meaningful impact on high yield spreads.

We remain constructive on credit fundamentals

In the near-to-intermediate term, we believe the potential downgrade risks are manageable and unlikely to manifest into a broader credit issue without a risk-off market event. Eventually there will be a downturn in the credit markets as the business cycle turns. The extreme growth in BBB corporate credit market, coupled with aggressive borrowing practices, is likely to give way to the next wave of fallen angels. While the timing of such an event is hard to predict and there will be consequences for credit markets, a rise in fallen angel activity also provides opportunities to active investment managers that are able to effectively manage client portfolios and navigate the crossover credit market from an investment grade and high yield perspective.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Aegon Asset Management or TEXPERS. 

Garry Creed

About the Author:

Garry Creed, CFA, is chief credit strategist responsible for credit strategy and oversight of the U.S. strategy team. He also provides oversight to the sovereign research team and Aegon Investment Management, B.V. research analysts. Garry is a member of the Senior Management Group and the Responsible Investment Technical Committee. Prior to his current role, Creed led Aegon’s Special Situations group, a predecessor to the current Distressed team. During his career, he has covered numerous industries for investment grade and high yield as an analyst. Prior to joining the Investment team, Creed served in various accounting and administrative management capacities. He has 28 years of industry experience and has been with the firm and its affiliates since 1988. Creed received his bachelor's degree from Wartburg College and his master's degree in business administration from the University of Iowa.