“Only when the tide goes out, you discover who has been swimming naked” – Warren Buffet. This quote possibly best describes the current reality of the BBB rated corporate bond space. U.S. investment grade (IG) nonfinancial bonds rated BBB now accounts for 48% of all IG bonds. In dollar terms, the total amount of BBB rated bonds outstanding currently is around $3 trillion as opposed to the $700 billion that was outstanding in 2007. Much of this phenomenon can be attributed to have manifested due to the extraordinary monetary policies that have been employed since the financial crisis. With the cost of financing at record low levels, companies have levered up their balance sheets to fund growth opportunities or fuel stock buybacks. A decade of recovery and economic growth has resulted in companies generating healthy profits and cash flows, but as the economic cycle enters the late stages, along with the FED well positioned for continued rate hikes and quantitative tightening, investors in the BBB rated corporate bond space would be well advised to tread lightly.

Credit Fundaments – Increased issuance alone does not necessarily signal risk, more important is to pay attention to the underlying credit fundamentals of the issuances. Since 2007, leverage for BBB credits has increased significantly as highlighted by the chart on the left, including a record 37% of companies having debt that is five times or more their EBITDA. Interest coverage ratios have also been on the decline over the past few years and this can be expected to further exacerbate due to the direct relationship between interest servicing costs and the FED’s hiking cycle.

Overall, the trend towards higher leverage over the past decade and the deteriorating interest coverage ratios over the last few years cannot be brushed away. This can prove to be troubling once the economy slows, and especially so for business cyclical sectors and sectors closely tied to commodity prices.

Outlook Ahead: Rise of the ‘Fallen Angels’ and the demise of the ‘Rising Stars’ ?

In order to answer this question, we need to understand the conditions that enable a ratings downgrade scenario. Over the past decade, the FED’s monetary policies have empowered excess borrowing without consequences due to having low debt servicing costs and a growing economy. However, that could all unravel if the next downturn is worse than expected, coupled with a hawkish FED. Research from Moody’s Investor Services, notes that typically 5% of Baa (Moody’s equivalent to S&P’s BBB) gets downgraded in a given year. But in a recession, that rises to 10%. Corporate debt outstanding as a percentage of GDP is at historic highs reaching levels last seen during 2000 and 2007. While some may take solace in corporate America sitting on a record $2.1 trillion in cash, a deeper dive reveals that 57% of that cash is held by only 25 companies and according to S&P, removing those 25 companies from the total reveals that approximately 450 companies with investment grade debt had cash-to-debt ratios more akin to those of speculative-grade issuers. The ingredients for a cascade of ‘fallen angels’ are there and based on estimates from PIMCO, close to $80 billion in U.S. corporate bonds currently rated BBB potentially could be downgraded below investment grade.

A Corporate Treasurer’s point of view – According to JP Morgan, over cycles, the typical firm’s lowest cost of capital tends to occur within the BBB ratings range. There are many factors that a CFO and a Treasurer will take into account when making capital structure decisions, however given that firms are able to have unencumbered access to capital markets at the BBB rating while being able to achieve the lowest cost of capital, it is likely that this may have influenced their decision making.

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