However, in our view, the risk of such a move materialising next year is limited and downgrades will be a function of idiosyncratic stories. That said, there are opportunities to be identified, and now more than ever, credit selection is key.
Source: ICE BofAML, Fidelity International, November 2018
As seen in the chart above, since 2008 the global BBB market has increased markedly and when compared to the size of the global high-yield market, its share has grown exponentially. However, it’s not only the size of these issuers that matters, it’s also their credit metrics. Leverage metrics for both USD and EUR BBB rated names have stabilised at much higher levels relative to pre-2008.
Interestingly, as the chart below shows, the change in leverage has been much higher in US defensive sectors such as healthcare, food and beverage and tobacco which have historically depicted more stable metrics. It’s also important to note that corporates have used the accommodative stimulus provided by central banks over the last decade in different ways, with US companies engaging in debt funded share buybacks, mergers and acquisitions and dividend distributions whereas their European counterparts have been more conservative when managing this liquidity injection.
Source: Fidelity International, November 2018
Profitability under pressure
Input cost inflation has been cited as one of the reasons for the reduction in corporate profitability over the past several months. Going forward, if this is coupled by a reduction in the top line revenue growth, due to a slowdown in global growth for instance, we can expect to see the profitability of companies coming under further pressure leading to elevated leverage metrics. Rating agencies, who so far have been very lenient in dealing with over-levered investment grade companies, could then overreact and downgrade such companies to high yield. The high-yield market is then faced with the task of digesting a large amount of bonds at a time when worries about global growth and corporate profitability would be at its peak.
It’s not just the downgrade from investment grade to high yield that can disrupt market valuations, it is also the move from A- to BBB+. General Electric has been a recent example of such a move, with about $115bn of debt entering the BBB space at the end of November. All three rating agencies proceeded to downgrade the issuer due to its excessive leverage and operational issues. Anheuser-Busch InBev, for similar reasons to General Electric, is another issuer that has been under scrutiny with Moody’s placing them on review for downgrade. Such moves can lead to meaningful underperformance for existing bonds, which sometimes can be greater than the one experienced when an issuer moves to high yield as a newly formed buyer base helps support spreads to some extent.
Our base case remains that the investment-grade downgrade cycle would be mostly driven by idiosyncratic names. Whilst we are cognisant of the effects a global growth slow down would have on accelerating such downgrades, our focus remains on evaluating the fundamental health of the credits we invest in. For us, credit selection is of utmost importance as we are actively investing in an asset class where avoiding the losers is even more important than picking the winners.