On Friday, Xerox became a fallen angel, after Moody’s followed Fitch and downgraded the company to junk citing, amusingly, “uncertainty about the company’s ability to stabilize and grow its revenue base over the next few years given the secular decline in copier and printing demand”.
Yes, as it turns out, nobody wants to make copies anymore and when it comes to printing things out on physical paper, that’s no exactly en vogue either. Needless to say, CDS spreads blew out on the news.
This of course comes at a time when the market is extremely concerned about fallen angel risk, given the proliferation of BBB credits. We’ve been over this ad nauseam but somehow, we suspect we’ll find ourselves spilling gallons more digital ink on the subject in the months ahead.
In the latest edition of the bank’s popular Flows & Liquidity series, JPMorgan’s Nikolaos Panigirtzoglou takes a look at where things stand as concerns mount and as IG spreads widen out amid growth concerns and ongoing turmoil across risk assets.
He starts by reminding you why this matters. In short, it’s not because a surge in fallen angels is a leading indicator. “In fact they tend to rather lag the credit cycle, but they are important in gauging the negative impact on credit returns”, Panigirtzoglou writes, on the way to spelling it out for anyone for whom this isn’t clear:
Rating downgrades or fallen angels drive a wedge between spread returns and total returns as the managers who are only allowed to hold investment grade bonds are forced to offload their downgraded bonds.
Incidentally, that actually applies to the ECB (see the Steinhoff debacle) but thankfully, the GC can always just rewrite the rules on that as it suits them.
Where do things stand right now? Well, in what is either a comforting sign or else exactly the opposite, Panigirtzoglou notes that “rating downgrade or fallen angel effects have barely started [as] the number of fallen angels in JPMorgan’s global high yield dollar denominated index still stands at very low levels typically seen at the beginning of a credit cycle.”
If that doesn’t work as leading indicator, how about ratings reviews? After all, it stands to reason that reviews precede downgrades. On that score, Panigirtzoglou writes that “similar to fallen angels, corporate downgrade reviews have yet to rise materially”. The last observation in the chart below (which covers EM, Western European and U.S. corporates), is for Q4.
So, is everyone freaked out for no reason? Well, no. As JPMorgan goes on to write, investors’ concerns are not unfounded. Net-debt-to-EBITDA is rising and clearly, the more you’re levered, the more trouble you’ll likely run into in the event the cycle turns, weighing on profitability at a time when interest rates are rising.
Zooming in on BBBs (i.e., focusing on what everyone is worried about), Panigirtzoglou warns that “the median net debt-to-EBITDA ratio for companies behind JPMorgan’s BBB indices in both the US and Europe has risen to above the peaks of the previous two cycles, especially in Europe.”
What he’s more concerned about, though, is the fact that “if one looks at the portion of BBB companies with net-debt-to-EBITDA ratio higher than the BB average of 2.3 in the US and 2.6 in Europe since 2001, this portion stands at 55% currently in both the US and Europe at the highest level in at least two decades.”
The implication there is clear, but in case it’s not, Panigirtzoglou drives the point home:
At face value, from a net-debt-to-EBITDA ratio point of view, more than half of BBB companies in the US and Europe look more like high yield than high grade.
And look, none of this is really “new”, per se. In fact, this is all anyone has been talking about for months and there’s an argument to be made that once something becomes as ubiquitous as this story is, the chances of it becoming systemic are thereby lower simply because everyone is aware of it.
If you’re looking for something that might be a bit off the radar, you might consider the following from Goldman which we’ll present without further comment other than to say that we highlighted it previously on November 14 (in the post linked above) and Goldman has been talking about it for months on end.
One of our core views in the BBB debate is that downgrade risk is higher among A-rated issuers than it is among their BBB-rated peers. This view has continued to play out through 4Q2018. Quarter to date, over $176 billion of debt has migrated into BBB territory from the A bucket; the highest amount since 4Q2015, which was a period characterized by a heavy wave of commodity-related “fallen angels” (Exhibit 1). As shown by Exhibit 2, $12 billion worth of bonds rated A- remain on downgrade watch. While this is a relatively modest number, we think it is worth bearing in mind that downgrades can – and often do – occur when a rating has a stable outlook. As such, while realized BBB downgrades have decreased the amount of bonds rated A- remaining on review for downgrade, we do not view this as a hurdle for future negative ratings actions. Over the long term, we continue to believe the risk of negative rating action in the high end of IG remains elevated, more so than in the BBB bucket.