Thus, it is that much of the decline in ratings is a change in the expected level of government support, particularly at the bank holding company level where debt is most often issued; we note that deposit ratings (the ratings on the group’s most senior obligations) are more aligned with pre-crisis levels. Given the fundamental strength of the sector described above, we contend the optics of lower aggregate ratings should not be a primary concern. Further, the increased issuance at the individual bank level is actually constructive as it built a necessary (and required) capital base. This is to say, there is effectively a positive impact from issuance, rather than negative association (i.e. leverage) one would find in other sectors.
The combination of these factors reinforces to us that ratings alone cannot be used to judge the evolving nature of credit quality that investors encounter. A holistic assessment of credit is needed, which entails an understanding of the individual sectors as well as an appreciation for the history of the markets to grasp today’s rating environment in context.
The referee ‘skin’
Inherent in the concern around BBB rated bonds is a belief in the impartiality of rating agencies. We make no secret of our healthy skepticism of the ratings assigned by agencies, not relying on them for the evaluation of an issuer’s credit quality. While our empirical observation is that many share our wariness of the agencies in evaluating an individual bond, this position seems to shift when discussing the market writ large.
The assignment of ratings is done with an understanding that economic cycles turn and conditions can become less favorable. As S&P states in their rating methodology: “Companies viewed as having strong fundamentals (i.e., those enjoying investment-grade ratings) are unlikely to see significant rating changes because of factors deemed to be cyclical, unless the cycle is either substantially different from that expected, or the company’s performance is somehow exceptional relative to that expected.”
This is not to suggest a recession would not prompt downgrades — economic stress can certainly impact companies differentially and the credit quality of some companies could materially deteriorate. However, it is clear that ratings agencies did not assign half of the U.S. corporate universe a BBB rating knowing that the first downturn we experience would create an avalanche of downgrades to high yield.
BBB downgrades: A battle royale?
In our view, part of the fear surrounding a wave of downgrades is recency bias — expectations that future recessions or economic downturns would be as destructive as 2008. Given a variety of metrics we have discussed in prior pieces, including both strong consumer health and reasonable corporate health as well as our view of lower systemic risk in the financial sector, our view is that the next turn in the business cycle will lead to a recession, but not a financial crisis. While certainly not a pleasant or desirable outcome, a more normal recession would be unlikely to cause the magnitude of damage that occurred in 2008.
Interestingly, even in the stress period of the financial crisis, a “wave” of BBB downgrades did not occur. In 2008 and 2009, for example, approximately 5% and 6%, respectively, of BBBs were downgraded to high yield. Over time, the annual downgrade rate for BBB to below investment grade is about 4.4% per year (Moody’s data for 1970-2018). Thus the 2008 and 2009 figures represent increased downgrades, but not a deluge. What was notable, however, was the lack of upgrades in those periods. By contrast to the approximately 4.5% a year of BBBs that have been upgraded historically, in 2008 and 2009 those figures were 2.3% and 1%, respectively.
In 2018, the downgrade rate for BBBs was approximately, 1.3%; this suggests that downgrades could triple from the 2018 level and rather than represent a “wave” would simply mean a return to normalcy. Ratings migration is part of the normal course of business, not reserved for economic downturns, but the recent period has been a relatively benign one for credit issuers, which has in some ways distorted expectations for investors.
Who will survive?
Default rates have been low, for example in 2018 the default rate was only 1.1% across all credit (investment grade and high yield). Thus even absent a clear catalyst, defaults are more likely to rise than fall over the coming period. Moody’s projects defaults across all corporates to rise to 1.5% in 2019, slightly below the 1.6% annual average since 1983.
2008 was, unsurprisingly, the worst single year for BBB losses (defaults less recoveries on those defaults). In that year, BBB bonds experienced a 68 basis point loss versus no loss for AAA bonds; at the same time, the average additional spread (as measured by OAS) for BBB versus AAA over the past 10 years has been 121 basis points. This is to say, if one were to indiscriminately hold BBB bonds and AAA bonds at their average yields to maturity, even in the worse stress year in recent memory, BBBs would have been the right call; this does not account for market impacts during that time when BBBs significantly underperformed. However, from a structural perspective, the yields offered by the BBBs outweighed the losses even in a terrible stress situation. Other factors, such as volatility, liquidity and uncertainty are included in the BBB premium, which can become apparent when examining market value impacts during periods of stress.
Thus, we do not dismiss concerns about increasing defaults or increased potential for downgrades, but our conclusion is not to avoid 50% of the market either. Indeed, higher quality bonds are not immune from downgrade or default risk, though they typically offer less spread cushion in the event of negative outcomes. For example, A rated bonds offered 60 basis points more on average than AAA bonds over the past 10 years and experienced a 27 basis point loss in 2008.
Conclusions — More Minecraft than Fortnite
On the scale of battle for survival to building a world, we place the BBB discussion closer to the Minecraft version. The decline in corporate ratings and the increased share of the corporate universe taken up by BBBs is due to a variety of factors. In some cases, lower credit quality metrics are indeed the culprit, but not exclusively; structural shifts have been significant over time.
From a pure credit perspective, we find it interesting that amidst the concern about BBBs, there is broader acceptance of other forms of credit, including bank loans and private debt, which are generally considered riskier than BBB corporates. While part of the appeal of these sectors is that they offer higher yields than higher quality counterparts, the same can be said, to a lesser degree, of BBB bonds. From a demand side though, we acknowledge the magnitude of the BBB universe is more than double the high yield universe, so theoretical mass downgrades create difficulty in finding buyers. Our view is that mass downgrades are unlikely to materialize, but were they to occur, it is not the newest entrants (i.e., downgrades), but the smallest constituents that are most likely at risk of losing sponsorship.
We do not dismiss the concerns building around BBBs, rather we seek to place them into a context and framework where we can understand how we arrived at today’s level of BBB bonds. We believe that the recent period has been particularly benign for credit and that it is entirely reasonable for downgrades and defaults to increase from today’s low levels. We do not agree with the Fortnite view of BBBs…but we aren’t entirely sad about the prevalence of this view either. If investors systematically fear a quality segment, it can create opportunities for those willing to take a deeper look — especially at the security level.