One of the principal concerns facing credit investors is the change in the credit profile of the investment grade corporate sector. As of December 31, 2018, BBB-rated bonds accounted for $3.2 trillion, or 50%, of the ICE BofAML U.S. Corporate Index. Since the financial crisis, the BBB-rated cohort increased by 17% and became the largest portion of the index.
Source: ICE BofAML Indices. Data as of December 31, 2018.
The increase in BBBs can be attributed to the rapid growth of supply in the overall investment grade credit market during the prolonged period of time when interest rates were artificially low after the financial crisis. Additionally, rating downgrades occurred during this period due to rising leverage, M&A transactions, and the energy crisis of 2015-2016. As a result, the opportunity set in BBBs is now significantly higher with over 700 issuers.’
Source: ICE BofAML Indices. Data as of December 31, 2018.
Given this backdrop, the current concerns emanate from the fact that the BBB-rated cohort is now the largest segment of the investment grade corporate market at a time when we are in the later stages of the credit cycle and economic data is exhibiting signs of slowing. However, we do not envision a mass deterioration in fundamentals in the near term as BBB-rated companies generally have had strong earnings growth and coverage ratios mostly remain healthy.
Source: CreditSights. Data as of September 30, 2018.
Source: CreditSights, ICE BofAML Indices. Data as of September 30, 2018.
In addition, we do not believe there will be a significant ratings migration to high yield. A sizeable portion of BBB-rated companies that have elevated leverage is comprised of large, industry leading companies (e.g. AT&T, Anheuser-Busch, CVS) with substantial free cash flow and have the levers to pull in order to maintain their ratings. Currently, the rating agencies have been fairly understanding and are giving these large, levered companies a reasonable amount of time to reduce leverage.
From a valuation perspective, BBBs generally provide a much better risk/return profile and better income generation capabilities in the investment grade universe. As of December 31, 2018, option adjusted spreads (OAS) were 78 basis points for AAA, 87 basis points for AA, 124 basis points for A, and 202 basis points for BBB.
In conclusion, we acknowledge the recent credit quality concerns in the market, but we do not believe that all BBBs should be painted with the same brush. Our primary concern is the individual risk profiles of the companies we invest in. The fundamentals and valuations of each company will drive the ultimate investment decision as opposed to a specific rating category. There will be fallen angels during the next downturn, but we believe the magnitude of the downgrades will be more likely a result of the idiosyncratic risks each issuer faces rather than the increased size of the BBB-rated cohort.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Senior Vice President, Investment Strategy
Boyd Watterson Asset Management, LLC