As we mentioned in our last research “Where should we go after 1Q 2019”, nearly every asset class posted strong positive returns in 1Q 2019. The lowest cusp of investment grade BBB-rated bond was one of them, climbed by 5.8% – the best first quarter performance since 1995, which totally dismissed the well-publicized fears of a “fallen angel” risks of downgrades to junk.
What is the “fallen angel” risks that matter the market?
The latest warning was from Bank for International Settlements (BIS), an organization for central banks to coordinate financial regulation world-wide, alarmed that the “fallen angel” threat of a firesale could be the most serious challenge facing the US corporate bond market during the next recession.
For instance, the Investment Grade (IG) bond market, in particular for the lowest IG grade rating BBB bonds (just one notch above Junk/High Yield (HY)), has experienced rapid growth since the Great Financial Crisis (GFC) and BBB debts now nearly accounts for almost 60% of the entire $6.4 trillion US IG space (vs. 48% in 2008) (figure 1). More importantly, as BBB bonds still fall into the low-risk category, portfolio managers of investment grade corporate bond mutual funds (which have rating-based mandates) were enticed by the tempting yields, and the share of BBB bonds in their portfolio has increased considerably to 45% from roughly 20% in 2010. Therefore, the rise of BBB footprint has left markets vulnerable to a crash once economic weakness triggers a spell of rating downgrades and market participants with investment grade mandates could be forced to fire sales its BBB bonds holdings, particularly for those with large downgrade risks. The value of force selling or portfolio rebalancing could potentially in excess of daily turnover in corporate bond markets and this may precipitate a downward spiral in the bond market. According to BIS, there could be over US$1 trillion in bonds could be cut to junk once the economic turns.
Figure 1. BBB as % of total IG
Source: Bloomberg, iFund/Noble Apex
Figure 2. BBB bonds in investment grade corporate bond mutual funds % has increased considerably
Source: Bloomberg, iFund/Noble Apex
The Key questions: how much of the BBB bonds are likely to be downgraded and could the market absorb the downgrades?
Is US$1 trillion overly pessimistic? According to Deutsche Bank (DB) credit strategist, the attrition rate of BBBs downgraded to HY in US has fallen towards historically low level in recent year (below 2% post GFC), which is unlikely to be sustainable, while the rate was above 10% last time when BBBs were also as a large proportion of the IG market. Therefore, at a more reasonable attrition rate of 10% when the US economy really slip into recession, the potential fallen angels could be over US$260 billion. This equals to 25% of the existing junk bond market and could be much higher than the US$142bn fallen angels in the last cycle in 2016. On another calculation and analysis, DB also suggested that there is actually a US$60bn fallen angel candidates in the US market even without an economy downturn. With HY net issuance in the US market has been no more than US$75bn in the last few years, the fallen angels could become a disaster.
In contrast, Invesco is one of the market participants that takes a relatively positive view to BBB bonds and see market concerns are overblown. Instead of including the “upper tiers” of US BBBs (BBB and BBB+), Invesco only counts the “lower-tier” BBB- companies in the calculation and sees companies in the highly cyclical sectors should bear the highest possibility of widespread downgrade during the economic downturn. By using the average historical attrition rate of 9.5% or peak rate of 14% in 2009 to the highly cyclical BBB- segment of US$460 billion, the potential rating downgrade size could be US$44 billion or US$65 billion. Also, rather than just purely looking at the HY market size, Invesco believes it should better to consider the entire leverage finance market size (including loans), which is at over $2.2 trillion with net debt issuance of US$187 in 2018.
Nevertheless, we believe the fallen angel risk is one of the key risks that bond investors should monitor this year and next year. According to S&P, the first quarter of 2019 had the most credit rating downgrades for U.S. companies than upgrade since the beginning of 2016. These downgraded names include utility PG&E (Baa3 to B2), retailer J.C. Penny (from B- to CCC+) and giant Walt Disney (from A+ to A). We may see some time in 2019 or 2020 when the market will start pricing the risk, leading to a rush of selling as investors try to get out ahead of every one else.
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