BBBs: Buyers Better Beware?

Matthew Chaldecott
Written by

24th September 2018

As we reach the tenth year of recovery and expansion, one of the outcomes has been the proliferation of investment grade corporate debt as companies have taken advantage of prolonged low interest rates. We have seen the US investment grade market more than double, in contrast to the US high yield universe, which has remained more stable.

Market size by face value, $mm

Similar story, different sector

Whereas the banking sector was the epicentre of the last financial crisis, we believe the next one may centre on industrials, particularly those in the BBB category who hover just above the investment grade threshold. BBBs have risen from around a third of the investment grade universe to nearly half. An economic downturn, and the associated erosion of earnings, cashflow and balance sheets, may leave these companies unable to sustain their credit profiles, and see them become the next wave of “fallen angels”.

We can trace the roots of this phenomenon back to corporate finance theory. Shareholders and management are incentivised to minimise the average cost of capital; this typically happens around 50% debt to equity, as the cost of equity plateaus:

Source: Brealey, Richard A. and Myers, Stewart C. (2003). Principles of Corporate Finance
Standard and Poor’s and Allianz Global Investors
* Note median levels of Debt/Book Capital vary by industry

In rating terms, this point falls around the BBB-mark, which means that companies above this level are motivated to increase their leverage, while those below should reduce it.

Where are the rating agencies?

Compounding our concern around the growth in corporate debt is the attitude of the rating agencies; the observed rating is often materially higher than that implied either by leverage or interest coverage:

Distribution of IG Index Par

Leverage is higher and rising

Drilling into the credit profile of the BBBs, we can see that the leverage prevailing here is substantially higher than was previously the case, and is pulling away from that of the single A category:

Net Leverage: A vs BBB-rated issuers

Deterioration in fundamentals is not adequately compensated

The deterioration in fundamentals theoretically should be compensated by higher spreads in an efficient market; instead we have seen spreads compress to near-historic low levels, with little margin for the risk of downgrade below investment grade.

Historical BBB vs BB Option-Adjusted Spread, bps

Caution warranted in BBBs

We are therefore exercising extreme caution in selecting investment grade corporates – at this late stage of the credit cycle, each issuer should be scrutinised carefully for its debt dynamics and its vulnerability to a deterioration in the economic environment.

Investing involves risk. The value of an investment and the income from it may fall as well as rise and investors might not get back the full amount invested. Past performance is not a reliable indicator of future results. This is a marketing communication issued by Allianz Global Investors GmbH,, an investment company with limited liability, incorporated in Germany, with its registered office at Bockenheimer Landstrasse 42-44, 60323 Frankfurt/M, registered with the local court Frankfurt/M under HRB 9340, authorised by Bundesanstalt für Finanzdienstleistungsaufsicht ( Allianz Global Investors GmbH has established a branch in the United Kingdom, Allianz Global Investors GmbH, UK branch, 199 Bishopsgate, London, EC2M 3TY,, which is subject to limited regulation by the Financial Conduct Authority ( Details about the extent of our regulation by the Financial Conduct Authority are available from us on request.