The Last Time BBBs Did This, Stocks Were At Record Highs

Who wants to talk some more about the “BBB apocalypse”?!

I’m just kidding. This story has been parroted, paraphrased and otherwise promulgated by every pundit, journalist and analyst on the planet over the past six months and we’ve certainly done our part to make sure the story retains its ubiquity.

Simply put, if the proliferation of BBB credit ends up contributing to the next crisis (via a turn in the cycle catalyzing a wave of downgrades to junk), it will be one of the more well-telegraphed crisis catalysts in the history of crises.

You already know the story by now. The BBB universe has mushroomed in size both in the US and across the pond and the worry, generally speaking, is that a sizable chunk of that gets cut to junk, leading to massive losses for IG investors and throwing the HY market into disarray. It’s also possible that large capital structures would find it virtually impossible to fund in the junk market, which could become an operational issue in a nightmare scenario.

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Most analysts are relatively sanguine about this, and one of the points we’ve been keen on driving home lately is that it’s entirely possible that the sanguinity is a product of nobody wanting to make “catastrophe” their base case.

Goldman and Barclays, for instance, have variously suggested that the “real” risk for high grade is intra-IG downgrades, not fallen angel risk. Of course if that means A —> BBB, there’s a sense in which it increases the risk of a mass junk downgrade assuming economic conditions continue to deteriorate.

For example, last Thursday Goldman noted that during Q4, more than $186 billion worth of bonds migrated from A into the BBB bucket. “That [brought] 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”, the bank wrote.

(Goldman)

As alluded to above, that 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 went on to caution.

Essentially, then, the whole thing hinges on the notion that the US economy is not in fact facing an imminent recession (anyone interested in this debate in the European context is encouraged to check out what we posted over the weekend here).

Ok, so that’s the backdrop for the YTD rally in BBBs, which we’ve documented on a number of occasions. Here’s where things stood as of Tuesday:

(Bloomberg)

That early optimism marks a stark turnaround from the doomsday calls that dominated Q4. In light of all this, we thought we’d highlight a particularly interesting factoid. BBB spreads have tightened for 10 consecutive sessions. The last time that happened, the S&P was at all-time highs.

(Bloomberg)

An admittedly superficial/probably naive read on that would be that the rally in BBBs has run too far, too fast.

The knee-jerk counter argument is that fears of the “apocalypse” were overblown.