Capital Ideas

Investment insights from Capital Group

Categories
Market Volatility
BBB bonds face their moment of truth
David Bradin
Fixed Income Investment Director
Hillary Cookler
Senior Investment Product Manager
KEY TAKEAWAYS
  • Downgrades of BBB-rated bonds to high yield are on pace to top their prior peak.
  • Fallen angel and BBB bond price declines can provide investment opportunities.
  • More downgrades are likely as the weak economy hurts revenue and cash flow.

Bonds rated BBB or Baa — the lowest rung of the investment-grade market — have ballooned to $2.3 trillion in recent years. Now, amid the economic crisis triggered by the coronavirus outbreak, a wave of downgrades appears to be underway, which could cause sharp declines in bond prices. In this Q&A, fixed income investment director David Bradin and senior investment product manager Hillary Cookler discuss the potential for further downgrades and the broader impact on this segment of the bond market.


What have we seen in the bond market as the crisis has unfolded?


The sharp economic downturn arising from the coronavirus pandemic has already taken a toll. More than 20 companies were downgraded to high yield (BB/Ba and below) during the first quarter, compared with 12 in all of 2019. These downgrades represented $143 billion of investment-grade (BBB/Baa and above) debt, close to the peak reached during the global financial crisis in 2009. Three “fallen angel” downgrades from BBB — Ford, Kraft Heinz and Occidental Petroleum — accounted for a large percentage of the downgraded debt. 


At the same time, market volatility spiked. In March, corporate credit spreads hit their highest levels since 2009, and Treasury market liquidity tightened considerably. Unprecedented intervention by the Federal Reserve — including a pledge to buy the bonds of investment-grade companies and recent fallen angels — helped to reduce volatility and narrow spreads. It also spurred record-breaking bond issuance as companies took advantage of historically low interest rates to build cash on their balance sheets in anticipation of a deep recession.


Chart shows the number and dollar value of BBB-rated nonfinancial corporate bonds downgraded to high yield from 2006 through the first quarter of 2020. In 2006, there were 22 downgrades of bonds valued at $30 billion. In 2007, there were 30 downgrades of bonds worth $51 billion. In 2008, there were 27 downgrades of bonds worth $56 billion. In 2009, there were 58 downgrades of bonds worth $150 billion. In 2010, there were 13 downgrades of bonds worth $28 billion. In 2011, there were 12 downgrades of bonds worth $38 billion. In 2012, there were 14 downgrades of bonds worth $27 billion. In 2013, there were 17 downgrades of bonds worth $41 billion. In 2014, there were 26 downgrades of bonds worth $37 billion. In 2015, there were 40 downgrades of bonds worth $143 billion. In 2016, there were 53 downgrades of bonds worth $86 billion. In 2017, there were 23 downgrades of bonds worth $20 billion. In 2018, there were 19 downgrades of bonds worth $48 billion. In 2019, there were 12 downgrades of bonds worth $17 billion. In the first quarter of 2020, there were 21 downgrades of bonds worth $143 billion. Source: J.P.Morgan.

 


Given the economic environment we are in today, do you expect further migration of companies from the BBB segment of investment grade to high yield? 


For much of the BBB segment, there is little immediate risk of downgrades to high yield. Many BBB-rated companies are large, with meaningful free cash flow generation, multiple ways to reduce leverage and a sizeable equity cushion below their debt. Such issuers can reduce or halt dividends, sell non-core assets to raise cash or prioritize the use of cash flows for net debt management in order to avoid a downgrade. 


Nevertheless, there are many BBB companies that entered the crisis in a weaker position and will likely be unable to avoid a downgrade. These companies are burdened by high net leverage, constrained liquidity, upcoming debt maturities or business models that are highly exposed to the economic dislocations caused by the pandemic.


Does that mean more fallen angels?


Yes, we think more downgrades and debt defaults are likely. Corporate leverage remains high and companies in many sectors are experiencing sharp declines in revenue and cash flow. After the criticism they faced in 2008–09 for being slow, credit rating agencies are moving aggressively to revise their outlooks and ratings as the economic fallout of the coronavirus pandemic comes into focus. Ultimately, it will depend on the depth and duration of the downturn and what actions BBB companies can take to avoid a downgrade. 


Sell-side analysts estimate that fallen angel downgrades could reach $350 billion for all of 2020. That estimate is consistent with prior downturns, when such downgrades hit roughly 15% of the total market value of BBB companies, excluding financials. If fallen angels reach that level, it would double the size of the BB bond market, which was valued at $349 billion at the end of the first quarter. While details about the Fed’s pledge to buy fallen angel debt are still emerging, its presence would help the market absorb these new entrants into the high-yield bond market and has already supported prices there.


What do these downgrades mean for bond investors?


Once a company’s debt reaches high-yield status, its bonds can come under forced selling by fund managers whose guidelines prevent or limit positions in securities rated below investment grade. The negative technical pressure of forced selling can result in price dislocation and volatility. An exaggerated downward price move triggered by a fallen angel downgrade can present an attractive buying opportunity for high-yield investors. 


So, do these price dislocations create investment opportunities?


Yes, absolutely. Credit markets are in flux as the trajectory of coronavirus infections and the depth and duration of the recession remain highly uncertain. Coupled with the effects of Fed intervention in the corporate debt markets, this can create situations where markets misprice bonds of both BBB companies and fallen angels, and corporate credit in general. 


Among BBB-rated bonds, wide spreads in many cases reflect high expectations of downgrades to high yield. This can be out of sync with the actual probability of a downgrade, as well as the issuer’s ability and commitment to preserve its investment-grade status. While the severe economic downturn will make it difficult for some companies to keep their investment-grade bond ratings, many managed to fortify their cash positions through debt issuance when markets reopened beginning in late March following the Federal Reserve’s massive injection of liquidity through its bond buying program.


How large has the BBB segment of the market become?


The overall investment-grade nonfinancial corporate bond market has more than doubled in size since 2011 as low interest rates have made it cheaper for companies to borrow. Over the same period, the value of BBB bonds swelled to around 60% of the investment-grade universe. It’s remarkable that, at $2.3 trillion, the BBB segment is bigger than the entire investment-grade market was less than a decade ago.


Chart depicts the size of the investment-grade nonfinancial corporate bond market from 2011 through the first quarter of 2020. Investment-grade bonds are those rated triple-B and above by rating agencies such as Moody's, Standard and Poor's and Fitch. It breaks out each year’s total dollar value between bonds rated BBB and bonds rated above BBB. It also shows the value of BBB-rated bonds as a percentage of the total value of the investment-grade market. In 2011, bonds rated BBB were valued at $883 billion and bonds rated above BBB were valued at $910 billion. In 2012, bonds rated BBB were valued at $1.089 trillion and bonds rated above BBB were valued at $1.016 trillion. In 2013, bonds rated BBB were valued at $1.247 trillion and bonds rated above BBB were valued at $1.139 trillion. In 2014, bonds rated BBB were valued at $1.379 trillion and bonds rated above BBB were valued at $1.224 trillion. In 2015, bonds rated BBB were valued at $1.613 trillion and bonds rated above BBB were valued at $1.264 trillion. In 2016, bonds rated BBB were valued at $1.612 trillion and bonds rated above BBB were valued at $1.595 trillion. In 2017, bonds rated BBB were valued at $2.009 trillion and bonds rated above BBB were valued at $1.653 trillion. In 2018, bonds rated BBB were valued at $2.325 trillion and bonds rated above BBB were valued at $1.512 trillion. In 2019, bonds rated BBB were valued at $2.391 trillion and bonds rated above BBB were valued at $1.627 trillion. In the first quarter of 2020, bonds rated BBB were valued at $2.332 trillion and bonds rated above BBB were valued at $1.657 trillion. The value of BBB-rated bonds represented 49.2% of the total investment-grade market in 2011, 51.7% in 2012, 52.3% in 2013, 53.0% in 2014, 56.1% in 2015, 50.3% in 2016, 54.9% in 2017, 60.6% in 2018, 59.5% in 2019 and 58.5% in the first quarter of 2020. Source: J.P. Morgan.

It’s worth noting that we focus specifically on the nonfinancial segment of the market for two reasons. First, financial issuer ratings tend to be more vulnerable under extreme market conditions, as we saw in 2008–09. Also, financial issuer debt is more highly concentrated by rating than nonfinancial corporate debt, with the vast majority rated A or BBB. Excluding financial issuers provides a better indication of downgrade and ratings risk across market cycles and ratings segments.


What drove the growth of BBBs?


A big factor was a sustained increase in corporate mergers and acquisitions fueled by low borrowing costs. Many higher rated companies received downgrades to BBB as they took on more leverage in pursuit of strategic acquisitions. In many cases, they also set forth credible plans to deleverage over time.


Another driver of growth for the BBB segment was so-called rising stars — formerly high-yield issuers that improved their credit strength enough to reach investment-grade status. The number of rising stars has exceeded fallen angels since 2017. This helped drive an improvement in BBB credit quality over the past few years. The weakest BBBs, those rated BBB- or Baa3, are at their lowest level as a percentage of all BBBs since 2013.


The chart depicts the credit quality of the BBB segment of the investment-grade nonfinancial corporate bond market from 2011 through the first quarter of 2020. Investment-grade bonds are those rated triple-B and above by rating agencies such as Moody's, Standard and Poor's and Fitch. For each year, it shows a breakdown between bonds rated BBB-minus, BBB and BBB-plus. It also depicts bonds rated BBB-minus as a percentage of all BBB-rated debt. In 2011, bonds rated BBB-minus represented 25.5% of the BBB segment, bonds rated BBB represented 39.1% and bonds rated BBB-plus represented 35.4%. In 2012, the breakdown was BBB-minus 20.5%, BBB 47.0% and BBB-plus 32.5%. In 2013, the breakdown was BBB-minus 24.0%, BBB 42.5% and BBB-plus 33.5%. In 2014, the breakdown was BBB-minus 27.0%, BBB 39.3% and BBB-plus 33.6%. In 2015, the breakdown was BBB-minus 24.7%, BBB 34.5% and BBB-plus 40.7%. In 2016, the breakdown was BBB-minus 24.9%, BBB 36.8% and BBB-plus 38.2%. In 2017, the breakdown was BBB-minus 29.1%, BBB 34.6% and BBB-plus 36.3%. In 2018, the breakdown was BBB-minus 25.2%, BBB 40.6% and BBB-plus 34.2%. In 2019, the breakdown was BBB-minus 24.5%, BBB 42.7% and BBB-plus 32.8%. In the first quarter of 2020, the breakdown was BBB-minus 24.3%, BBB 41.7% and BBB-plus 34.0%. Source: J.P. Morgan.

 


Are all BBBs potentially at risk of falling into high yield?


For much of the BBB segment, there is little immediate danger of downgrades because they have levers to pull to keep their investment-grade ratings.


For some companies that fell to BBB after acquisitions, the severity of the economic downturn will make it more difficult to follow through on their intentions to deleverage. Still, many of them raised cash by issuing debt in late March when the new issue market opened up after the Fed’s intervention. Strong investor demand for this new debt was an important vote of confidence in those companies.


That said, there are also many BBB companies that entered the crisis in a weaker position. Others came into it in good shape but have suffered significant damage to their businesses as a result of the pandemic. Many of these companies will likely be unable to avoid a downgrade. 


How is Capital navigating this landscape?


We believe that active managers who can assess the risks and opportunities of a potential fallen angel downgrade can provide significant value to investors. As active managers, we’re able to discriminate among fallen angels and BBBs based on our deep fundamental research. Our analyst teams examine each issuer’s business model, economic dependencies and financial condition to determine the probability that it can maintain its ratings. They also draw on their close long-standing relationships with management teams to evaluate a company’s intentions and commitment to its current ratings.


So, we might conclude that it makes sense to remain invested in a fallen angel in anticipation of a recovery in the price of its bonds, while a passive investor may be forced to sell the same holding, regardless of the company’s underlying fundamentals.


We’re also benefiting from close collaboration between our investment-grade and high-yield investment teams. A fallen angel is effectively a new company entering the high-yield universe. It may not be well known or well covered by many high-yield investors. The collaboration between our teams provides seamless research coverage and intelligence across the rating spectrum.



David Bradin is Fixed Income Investment Director for credit strategies. He has 14 years of industry experience. He holds an MBA from Wake Forest University and a bachelor's from North Carolina State University.

Hillary Cookler is a senior investment product manager at Capital Group, home of American Funds. She has 14 years of industry experience and has been with Capital Group for one year. She holds an MBA from Yale School of Management and a bachelor's degree in history and economics, graduating magna cum laude, from New York University. Hillary is based in Los Angeles.


Bond ratings, which typically range from AAA/Aaa (highest) to D (lowest), are assigned by credit rating agencies such as Standard & Poor's, Moody's and/or Fitch, as an indication of an issuer's creditworthiness.

Hear from the investment team.

Don't miss out

Get the Capital Ideas newsletter in your inbox each week

*REQUIRED

Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.

Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the mutual fund prospectuses and summary prospectuses, which can be obtained from a financial professional, and should be read carefully before investing. Similar information about collective investment trusts can be obtained from Capital Group or participants' plan provider or employer.

All Capital Group trademarks mentioned are owned by The Capital Group Companies, Inc., an affiliated company or fund. All other company and product names mentioned are the property of their respective companies.

Use of this website is intended for U.S. residents only.

American Funds Distributors, Inc., member FINRA.

This content, developed by Capital Group, home of American Funds, should not be used as a primary basis for investment decisions and is not intended to serve as impartial investment or fiduciary advice.

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information is intended to highlight issues and should not be considered advice, an endorsement or a recommendation.