Financial media and investors have been focusing on the BBB segment of the U.S. investment grade (IG) corporate bond market this year. At $3.1 trillion in market capitalization (nearly quadrupled from a decade ago), BBBs constitute nearly half of the investment grade corporate universe, according to the ICE BAML U.S. Corporate BBB and U.S. Corporate Master indices.
There are generally two concerns around BBBs: 1) refinancing risk as interest rates rise and 2) downgrade risk into the high yield or “junk” bond universe, especially for the lower rated or BBB− portion of the BBB cohort.
U.S. BBB nonfinancials have generally evenly distributed maturities, with a significant portion maturing ten years out or beyond (source: ICE BAML U.S. Corporate BBB Index and J.P. Morgan data). This suggests refinancing risk is somewhat manageable despite interest rates being higher today. It’s a very different picture from the large leveraged-buyout-driven “maturity wall” that was a big concern for the high yield and loan markets in 2008.
Concerns around downgrades to high yield are most relevant for U.S. BBB− rated issues that have a negative outlook or negative watch from at least one rating agency. Credit Suisse estimates there may be close to $95 billion of such securities, largely concentrated in pipelines, media and technology sectors. While many of these issues may not end up being downgraded, $95 billion is by no means a staggering figure in the wider context of the $1.3 trillion U.S. high yield market, which has seen essentially no growth for the last four years. We also note that in the U.S. so far in 2018, upgrades to investment grade (“rising stars”) have actually outpaced downgrades into high yield (“fallen angels”) by a ratio of 1.7x, according to Credit Suisse.
On the other hand, some of the most levered BBBs are those associated with recent M&A transactions that expect to rely on continued M&A synergies and debt paydown to maintain their IG ratings. These bonds could be especially vulnerable during an economic slowdown that pressures cash flows and forces them to make tough choices to remain IG.
In addition to that, in the broader IG market the rating deterioration has continued, with 2018 YTD downgrades (from higher to lower ratings within IG) outpacing upgrades by 2x according to J.P. Morgan, even amid healthy economic GDP/earnings growth.
All of this means that careful credit selection and active portfolio management will likely play a crucial role in mitigating losses from fallen angels when the next downturn hits.
Watch our “Quick Takes” video on how active management can help manage risks while seeking opportunities in the ballooning BBB market.
Hozef Arif, Jelle Brons and Lillian Lin are credit portfolio managers in PIMCO’s Newport Beach office.