“Shouting” about the “BBB cliff” isn’t confined to US credit strategists.
The “fallen angel risk” story has become ubiquitous stateside as analysts, pundits and commentators of all shapes and sizes weigh in on the dangers inherent in BBB’s outsized representation in the investment grade credit universe. The cat calls reached a fever pitch in Q4 when, as documented here on Friday, more than $186 billion worth of bonds migrated from A into the BBB bucket, the largest such “migration” since 2015.
One of the mitigating factors in the US is, ostensibly, low recession risk. For a mass downgrade that sees large capital structures cut to junk to play out, the cycle probably needs to turn and the notion that a US recession remains unlikely in 2019 is part and parcel of any benign take on the “BBB apocalypse” story.
So far in 2019, BBBs have outperformed.
But as alluded to above, this story is perhaps even more pressing across the pond, considering the increasingly dour economic outlook as evidenced by recent data out of Germany (which seems to be on the edge of a “technical” recession). Indeed, the stark juxtaposition between the decelerating economic data and the ECB’s decision to move ahead with APP wind down is the talk of the proverbial town when it comes to the outlook for European risk assets.
Here’s a chart of eurozone GDP with the ECB’s balance sheet and what you want to note is that the balance sheet was always growing during previous soft patches, whereas now, net asset purchases have ceased.
“Probably the most consensus topic in credit meetings at the moment is the ‘BBB’ cliff story in Europe”, BofAML’s Barnaby Martin writes, in a note dated Tuesday, adding that despite the attention the story is getting, his team “feels” the need to “shout about this risk even louder in an environment where European economic momentum has slowed meaningfully, and where the growth risks are still firmly to the downside.”
Right off the bat, Martin says the bank remains constructive on US BBBs precisely because, as noted above, the economic outlook is better. In Europe, on the other hand, the outlook seems to be getting progressively worse. Indeed, Draghi acknowledged the downside risks in his post-meeting presser on Thursday (see the linked post).
Martin reminds everyone that the size of the BBB market in Europe has exploded – face value jumped by some €100 billion last year and is now three times the size of the HY market. Have a look at this:
Given that disparity, it stands to reason that any downgrade cycle (i.e., even one that isn’t all that dramatic, relatively speaking) would be destabilizing for the € junk market.
And that’s where the problem comes in. To wit, from the note:
In chart 11, we overlay the Fallen Angel cycle with the Euro Area OECD Lead Indicator, (and show it as a 2yr trailing Z-score). As can be seen, such negative readings on the OECD lead indicator have usually driven fairly material Fallen Angel cycles over the following year. The only exception was in 2016, where the Fallen Angel cycle was muted – but we think this was likely a result of ECB CSPP transforming the outlook for credit markets.
So, yeah – that looks really, really bad. You can kinda, sorta “quantify” it, where that means extrapolate how much BBB debt would be downgraded based on that leading economic indicator, and from where BofAML is sitting, the figure would be roughly €50 billion. As Martin writes, “this would be 21% of the current high-yield market size.”
Clearly, this whole thing was deliberate, and no, “deliberate” does not carry a conspiratorial connotation. Rather, the whole point of CSPP was to broaden access to credit and that’s precisely what happened.
“The big contributor to BBB market growth of late has been debut issuers tapping the bond market [and] this is exactly as Draghi wanted it, when he argued in 2016 that CSPP would provide access to credit for those most in need”, Martin continues.
That’s all fine and good until the CSPP bid goes away and/or until the cycle turns. In other words: that was all fine and good until right now.
Something to think on.