BBBs: Buyers Better Beware?
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.
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:
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:
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:
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.
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.