Fixed Income Boutique

How healthy is the credit market?

Viewpoint

Global yields are near record lows and the race to find positive yielding bonds is intensifying. Typically, investors tend to compromise in this type of environment and set their sights on higher-risk assets. We often receive questions about the health of the investment-grade market, in particular on BBB or BB rated companies, including the US.

So, let’s start with a closer look at BBB rated companies (and potential “fallen angels”, companies downgraded by a rating agency from investment to speculative grade). This rating segment has been growing for the past decade. Interestingly, most BBB rated companies have done their homework, by deleveraging their balance sheets. The majority have kept the ratings stable and have not become fallen angels. Companies with a single-A rating instead have been the ones where leverage has increased most over the last few years.

The statistics tell us that the majority of investment-grade rated companies, around 90%, remain in investment-grade territory over a five-year horizon. However, it’s important for investors to understand the reasons for potential downgrades.

When looking at the dynamics triggering a downgrade over the past 20 years, it’s generally one (or a combination) of two things:

  1. Company specific factors, such as deteriorating financial metrics, or
  2. Industry stress, such as the effect of a drop in oil price in 2016 in the energy sector, for example.

The above two reasons explain roughly 70-80% of downgrades from investment-grade to high-yield territory according to Moody's.

What is clear is that recent years show a decline in the number of fallen angels, indicating a benign business environment with companies in good health (see chart 1). This should help investors sleep a little better at night, since blow-ups are ever more irregular.

2019-11-07_fi_how-to-capture-bonds-destined-for-an-upgrade_chart1_en

 

When analyzing the latest trends in the US, for example, we also continue to see improving rating migration trends within the BB rated space, with fallen angels being outpaced by “rising stars” (companies upgraded by a rating agency from high yield to investment grade). Since 2017, rising stars have increased to 97 billion US-dollars and just 39 billion US-dollars of fallen angels.

2019-11-07_fi_how-to-capture-bonds-destined-for-an-upgrade_chart2_en

 

We believe this positive trend is set to continue and we will continue to seek potential rising stars.

So, what’s in store for investors in the near future? By focusing on the likely big movers (upgrades and downgrades) investors can benefit twofold:

  1. By avoiding fallen angels. Bonds from these companies usually underperform the broader market.
  2. By detecting rising stars early. Strong spread tightening tends to go hand-in-hand with upgrades.

At Vontobel, we actively look at both the “angels” and “stars”, aiming to detect them early.

From our viewpoint, the corporate-credit market is in a favorable state. Most BBB rated companies have improved their leverage metrics, the number of fallen angels is low, while the number of rising stars is high. This is one of the areas in the developed-world bond universe where investors can still earn decent returns.