Headlines surrounding the growth of BBB-rated corporate debt are beginning to mount. And for good reason. Since 2007, the BBB-rated segment of the public credit market has grown by 265%. By comparison, the high yield market has only grown by 102% during the same time period (Figure 1).
As of 9.30.2018. Source: Bloomberg Barclays. BBB as represented by the Bloomberg Barclays Baa Corporate Bond Index. High yield as represented by the Bloomberg Barclays High Yield Index.
While many have been quick to highlight the growth off BBB-rated debt as a warning sign of something more ominous (and immediate), a closer look at the data and evolving credit market dynamics paints a more nuanced picture.
No immediate threat
On the surface, the sharp increase in BBB-rated debt seems concerning, particularly against a backdrop of higher net leverage and declining coverage ratios. However, while risk is present, we believe it is less acute than headlines imply. For starters, technology companies, a sizeable component of BBB issuers, added leverage from a relatively low base. In addition, for the highly leveraged BBBs, many of these issuers are large and less cyclical than the overall market, e.g. healthcare, consumer, and consumer-oriented tech.
Leverage calculations also vary and have different implications. An average of leverage ratios or an aggregate debt to EBITDA calculation is susceptible to the influence of outliers and tends to overweight the influence of large companies. Ratios using median data points paint a less concerning picture of the fundamental corporate credit landscape. More broadly, credit markets are being supported by strong corporate earnings, as positive revenue and EBITDA growth are helping offset higher net leverage and declining coverage ratios.
Therefore, while pockets of risk undeniably exist, we do not believe that the current glut of BBB-rated debt poses an immediate threat to the broader credit markets. However, in this environment, security selection, which is always a vital component of corporate credit portfolio construction, is more critical than ever.
What we’re keeping an eye on: The loaded spring
While there appears to be no clear and present danger, we do have longer-term concerns. The corporate credit landscape has changed materially in the last ten years and these new market dynamics could accelerate volatility during the next downgrade cycle. A closer look at Figure 1 shows the relatively smaller size of the high yield market versus BBB-rated debt. In fact, senior loans, once an esoteric, off-the-run asset class, now constitute a larger portion of the credit market than unsecured high yield bonds.
In addition, the growth in BBBs has been most pronounced among longer duration bonds, i.e. bonds with a duration of 10+ years. Why does this matter? Historically, the high yield market has absorbed downgraded BBB debt, demand that helped stabilize credit markets and provide a buffer against market volatility. However, longer-dated bonds are typically shunned by high yield investors. This means the high yield market, already diminished in its capacity to absorb downgraded BBB debt given its relatively smaller size, will likely be even more constrained in its willingness to buy downgraded BBBs given that most of the bonds are long duration. Looking at the size of existing BBB-rated long-duration bonds next to existing high yield debt is particularly concerning. Long-duration BBBs outstanding are almost the size of the entire high yield market. This evolution of the credit markets has the potential to create an unexpected supply/demand imbalance during the next downgrade cycle. In the event of future credit market volatility, buyers previously depended on to bring pricing stability may be few and far between. While we do not believe a downgrade cycle is imminent, we are certainly in the latter stages of the business cycle, particularly as it relates to corporate credit. Yet another reason why security selection is more important than ever in this environment.
In line with our theme of insulating portfolios from “downside velocity” this is a risk we will be paying particularly close attention to going forward.
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