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    Credit Insights: Embracing the great BBB convergence

    Credit Insights: Embracing the great BBB convergence

    March 11, 2021 Fixed income

    The BBB market is becoming the core of the investment grade universe, a fact we believe investors should embrace. We also believe high yield, particularly rising stars, currently offers a compelling complement to BBB in a core credit allocation.

    Executive summary

    • The highly rated (AAA to A) market is migrating to BBB on a secular basis as companies take advantage of low yields to optimize their overall weighted average cost of capital (WACC).
    • Cyclically, an investible component of the high yield market is also migrating to BBB given the near-term outlook for Rising Stars (high yield companies upgraded to investment grade).
    • As such, we believe BBB is the structural sweet spot for credit investors, providing the deepest and most diversified corporate bond universe.
    • We also continue to see strategic value within high yield and believe investors should consider credit strategies with the latitude to capture potential value in areas such as these.

    Contents


    The AAA to A rated corporate bond market is drying up on a secular basis

    The proportion of corporate investment grade issuers rated “A” or above is in long-term secular decline with BBBs increasingly dominant in both the all-maturity and long-duration credit markets (Figure 1). By market value, BBBs account for ~50% of the market.

    Figure 1: The number of issuers rated A or above is proportionately shrinking1

    15472-CreditMigration_Chart1_840x300px.jpg

    No cause for concern, in our view

    In the 1980s, it was structurally common for large bellwether corporates to maintain AAA ratings, but a secular decline in interest rates and credit spreads has made BBB the new optimal capital structure, resulting in downgrades to BBB.

    To demonstrate, in 2000, investment grade yields were ~7.5% to ~8% but are now ~2.1% to ~2.6%. As such, the cost of debt for many firms is no longer comparable to their cost of equity – which is ~8.5% on average for S&P 500 companies2.

    Therefore, we believe it makes sense for corporate capital structures to increasingly skew toward debt over equity (i.e. higher leverage). The weighted average cost of capital (WACC) associated with a BBB rating has gone from the most expensive to the cheapest, if there is no associated credit distress (Figure 2).

    Figure 2: On average, the WACC associated with a BBB rating has gone from most expensive to cheapest3

    15472-CreditMigration_Chart2_840x300px.jpg

    As such, we do not see this trend as cause for concern from a credit risk perspective, but reflective of sensible management decisions.

    Another $1.5trn may be downgraded to BBB over time

    We project that roughly half of the remaining A or better universe is likely to be downgraded to BBB for the reasons noted above.

    We believe the only major sectors that will structurally opt to retain high credit ratings are financials, such as banks (whose business models are predicated on lending at higher rates than they borrow), insurance companies and operating utilities companies (given their structural debt seniority over their holding companies – which are often rated BBB).

    This leaves a sizable universe of industrials, amounting to ~$1.5trn and ~$0.7trn for the all maturity and long-dated corporate indices respectively that may yet opt for downgrades (Figure 3).

    Figure 3: Roughly half the broad and long-dated AAA to A market may yet opt for downgrades4

    15472-CreditMigration_Chart3_840x300px.jpg

    We have based these figures on the following assumptions:

    • All AAA to A financials remain above BBB
    • All AAA to A operating company utilities remain above BBB
    • 5% of AAA to A industrials by market value choose to remain above BBB (for idiosyncratic management reasons or preferences)

    By rating, most of these long-term names at risk of a downgrade are within the “A” bracket, indicating a significant proportion of these universes could potentially enter the BBB market sooner rather than later (Figure 4).

    Figure 4: Bonds at long-term downgrade risk are skewed towards single A, just above BBB4

    15472-CreditMigration_Chart4_840x300px.jpg

    Notably, many high yield names are also converging toward BBB

    The BBB market is also currently absorbing upgrades from BB and below (known as “Rising Stars”), not just downgrades from A and above (Figure 5).

    Figure 5: Rising Stars to Fallen Angels ratio spiked in 20215

    15472-CreditMigration_Chart5_840x300px.jpg

    There are also structural forces that can incentivize high yield corporates to chase upgrades to BBB. As corporate credit ratings fall into high yield, the WACC benefits diminish, and debt comes with additional constraints.

    The high yield market is less than a fifth of the size of the investment grade market, so high yield issuers can see less demand and lower liquidity for their debt. Another demand constraint is less favorable insurance statutory capital treatment. As a result, high yield corporates sometimes need to include additional bond covenants to raise debt.

    Further, the spread “cliff” between investment grade and high yield bonds is significant at ~80bp for BB and ~200bp for B , making the cost of debt significantly more onerous for high yield companies on average (Figure 6).

    Figure 6: The spread penalty for high yield versus investment grade is significant7

    15472-CreditMigration_Chart6_840x300px.jpg

    BBB currently offers the deepest and most diversified universe

    We call the tendency of credit issuers to gravitate to BBB the “great convergence” (Figure 7).

    Figure 7: The great BBB convergence illustrates how credit is gravitating to BBB8

    15472-CreditMigration_Chart7_840x300px.jpg

    We project that the all-maturity investment grade corporate index will be rated BBB on average by the end of 2023, with the long-dated index set to follow by ~2025 (Figure 8).

    Table 1: The average investment grade rating is gravitating to BBB9

    Weighted average rating 2011 2021 2023 (Projection) 2025 (Projection)
    All maturity corporate A A- BBB+ BBB+
    Long duration corporate A A- A- BBB+

    We believe the BBB market increasingly offers better access to credit themes and active management opportunities than the AAA to A market, such as:

    1) Deleveraging names

    Many companies have recently completed large M&A transactions or share buybacks and are now on a deleveraging path to avoid further downgrade to high yield, and so are actively selling businesses and raising cash to deleverage.

    2) Stable BBB names

    Given many companies find an optimal capital structure at a credit rating of BBB, many have displayed a commitment to maintain BBB ratings through multiple cycles, such as certain retailers, car rental or chemicals issuers, telecoms and utility holding companies (which tend to receive stable dividends from their operating companies).

    3) Pro-cyclicals

    As the economy continues to grow, cyclicals, particularly those that may have suffered at the start of the pandemic, could be well-placed to recover and grow into their capital structures, potentially benefiting from spread tightening and / or ratings upgrades.

    4) Higher-yielding names

    Corporates with the highest yields offer compelling carry in a low-yield world. They also provide a spread “cushion” that can absorb a greater degree of protection from rising rates and price appreciation potential from rising rates.

    As a complement to BBB exposure, look to high yield over highly rated credit

    Tactically, investors should complement their BBB exposure with bonds most likely to be upgraded rather than downgraded – i.e. high yield rather than AAA to A rated credit.

    Highly rated portfolios are increasing vulnerable to concentration and downgrade risks

    The top 10 issuers (which include industrials) currently account for ~25% of the long-dated and all-maturity AAA to A indices . As such, single downgrades can potentially damage a larger proportion of credit portfolios.

    Consider that an AAA issuer with a 60bp credit spread and a duration of 15 years would only need to see 4bp of widening before the bond’s entire year of spread carry is wiped out by its price fall. Compare that to the actual impact as a downgrade would likely cost an issuer ~50bp to ~70bp of widening based on current market pricing.

    We estimate that if a top-10 issuer was downgraded to BBB, it could cost an entire long-duration high grade portfolio ~25bp and an all-maturity portfolio ~10bp of performance respectively (or months of portfolio-level spread carry).

    Meanwhile, in high yield, the outlook is brighter, particularly for Rising Stars

    We forecast $250bn of Rising Stars in 2022. This is a cyclical event that we believe currently presents an opportunity.

    This is partly because we see the current growth environment to be supportive. Historically, the asset class has seen its strongest performance in more moderate growth environments, which is consistent with our outlook for 2022 (Figure 8).

    Figure 8: The current growth environment could be the sweet spot for Rising Stars11

    15472-CreditMigration_Chart8_840x300px.jpg

    Figure 9: 2022 could be a potentially strong year for Rising Stars12

    15472-CreditMigration_Chart9_840x300px.jpg

    BBB and BB companies are already core holdings for many investors

    Investors already have abundant exposure to companies rated BBB and below through their equity allocations. Consider that ~50% of the names in the S&P 500 Index are BBB, and ~25% are rated between BB to CCC . Of the remaining, 21% are rated A, just one notch above BBB, with only 4% rated either AAA or AA.

    Equity, of course, is at the very bottom of the capital structure. As such, from a structural perspective, senior debt in issuers that are household names and rated BBB or BB makes sense, in our view, as part of a staple fixed income allocation if an investor is otherwise comfortable holding S&P 500 constituent equities.

    Conclusion: BBB is the sweet spot, and tactically consider high yield over high ratings

    BBB has become the new normal in investment grade and should be the heart of any investor’s core corporate credit allocation.

    Investors are used to thinking of AAA to A rated corporates as the most dependable. However, in some ways they may be riskier than BBB companies given downgrade risks that are not compensated by the scant credit spreads on offer.

    If necessary, investors should expand their guidelines to increase below-investment grade allocations and relax any minimum average quality constraints to maximize the opportunity. Also tactically, a dedicated Fallen Angels strategy could be considered a reliable way of capturing future Rising Stars.

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