The last time we weighed in on the “great” BBB debate was – checks notes – Tuesday.
“IG Credit Potpourri: BBB Apocalypse Update And A Liquidity Check” turned into a kind of rambling stumble through recent market action which included the best day for IG credit since 2016 (where that means spreads came in 5bps last Friday). We’re now some 23bps tighter from the local wides.
(Bloomberg)
Meanwhile, BBBs have continued to outperform, perhaps helping to allay “fallen angel” fears, which dominated the credit discussion in Q4.
(Bloomberg)
Of course just because 2019 has provided something of a Goldilocks environment for BBBs (think: dovish Fed shift and rapidly tightening junk spreads, with the latter presumably making BBBs relatively appealing) doesn’t mean folks are going to stop shouting from the rooftops about the prospect that mass downgrades will ultimately spell horrendous losses for IG investors and throw the high yield market into complete disarray.
Most analysts are relatively sanguine about that, but it’s entirely possible that the benign takes emanating from credit desks are a product of nobody wanting to assign a high probability to what would be a catastrophic event.
“A downgrade to high yield for some of the large capital structures could have drastically negative implications”, Barclays wrote earlier this month, adding that “not only would funding costs increase significantly, but funding a large capital structure — each of the top 10 BBB would be more than 2% of the High Yield Index if downgrade — in the high yield market might be downright impossible.” Right. And the note from which that quote is excerpted is a case in point when it comes to analysts acknowledging that the worst case scenario is unthinkable and therefore will probably be averted. That’s tantamount to confirmation bias.
With all of the above in mind, it’s worth noting that during Q4, more than $186 billion worth of bonds migrated from A into the BBB bucket. As Goldman writes in a note dated Thursday evening, that “brings the total amount of downgraded bonds to $278 billion for the full year… the highest tally since 2015, when a change in rating agency methodologies triggered a series of downgrades of US Banks.”
(Goldman)
Naturally, that only makes the “problem” worse – that is, it increases the size of the BBB market. “This significant acceleration in the pace of downgrades among A-rated non-financials has further boosted the size of the BBB market, which now stands at $3.35 trillion in notional value — up by $400 billion vs. the beginning of 2018”, Goldman goes on to note.
(Goldman)
Is this a problem? Well, that depends on how you want to look it.
For their part, Goldman takes a glass half full approach, flagging low recession risk, “a more conservative mindset for capital structure management among BBB issuers relative to higher rated issuers” and, somewhat amusingly, “a high bar for a large negative earnings shock that would fuel a wave of downgrades among the largest BBB-rated issuers” as factors that mitigate fallen angel risk.
Don’t expect that to placate skeptics and doomsayers, though.
Especially not when the “problem” (where that means the size of the BBB market) is getting bigger all the time.
Black knight says, “Tis but a scratch!”