The warnings were stark. A year ago, commentators were queuing up to forecast the risks to the corporate bond market from BBB bonds becoming a bigger and bigger component of the market. After all, BBB-rated bonds grew from less than 10 per cent of the market 20 years ago to almost 50 per cent today. Warnings about what would happen in the next downturn abounded. Because the high yield market is less than a fifth of the size of the investment-grade corporate bond market, it was thought that it wouldn’t take many bonds falling from investment grade to high yield to swamp the latter. While this has always been a factor, the risk is all the greater now, given the growth in the BBB portion of the market, highlighted in the chart below.
Large scale quantities of freshly junked bonds would cause chaos. Many investment-grade companies are multi-nationals with mega market caps and similarly large amounts of debt in the form of corporate bonds. The world’s largest issuer of corporate bonds is AT&T. It has a market cap of $204bn with approx. $170bn of corporate bonds outstanding. It is rated BBB by S&P and Baa2 by Moodys. If AT&T were to fall on harder times and be downgraded to junk, at a stroke it would increase the size of the global high yield market by nearly 7%.
Thankfully the likelihood of that is low for the foreseeable future, but it does display the outsized nature of the problem. On the whole, investment-grade companies are big with lots of debt and high yield companies are smaller with less debt. When investment grade funds become forced sellers of fallen-angel bonds, the high yield funds struggle to digest the glut of fresh supply into their market. Clearly the more BBB bonds in existence, the greater the threat.
While this risk of mass downgrades is real, the most important question is: is that likely to happen? Now that we are well through 2020, it’s a good time to test the theory of the vulnerability of the corporate bond market and BBB bonds in particular. After all, we’ve had a very significant economic downturn. If the BBB dog was ever going to bite, surely this would be the year with the global pandemic and all-time record quantities of BBB bonds.
Well, the year isn’t over yet. And there are still 10 weeks for more downgrades to come, but only 2.5 per cent of the sterling investment-grade corporate bond market has been ‘junked’ in the first three quarters of 2020. This is not an outlier by international standards with only 2.1 per cent of the European investment-grade corporate bond market being junked so far this year.
How does 2.5 per cent compare with other years? Pretty well is the simple answer. It’s up considerably from extremely modest levels in the years 2016 to 2019, but it’s in line with the years 2012 to 2015. Yes, more downgrades will come, but 2020 will not prove to be a bad fallen-angel year. And, of course, some downgrades will be a slow burn and will lose their status in 2021. Buts it’s all very manageable.
The outlying year, however, was 2009 when about 9 per cent of the sterling investment-grade corporate bond market was ‘junked’. The sterling corporate bond market was very heavily skewed to subordinated financial bonds back then, about 38 per cent compared to about 12 per cent today. While most banks’ credit ratings never fell to junk status, a great many of their deeply subordinated bonds were.
That did lead to a swamping of the market with heavy downward price movements before a rapid recovery. But you could argue that was a sector-specific problem which was caused by an oversized part of the market. There has never been anything like it before or since. In the final counting, 2020 might prove to be the second worse year for downgrades in the last 20 years; but it’s looking unlikely that it will surpass 2015 when downgrades hit about 3.5 per cent of the market.
So why, in the face of the worst recession in living memory, has it not been much worse? Well, rating agencies are meant to rate companies through the lens of a complete business cycle: somewhat ‘glass half-empty’ in good economic conditions and a bit ‘glass half-full’ in leaner times. Now it doesn’t always work out like that clearly, but rating agencies do have and can show tolerance if they see a plan in place to restore balance sheets’ health. And that has largely happened. Dividends have been cut orf stopped temporarily, as have many share buy-back schemes. Some of the most pandemic-exposed businesses have conducted rights-issues. The Bank of England has created commercial paper facilitates and the Treasury is backing business loans, giving VAT payment holidays and employee protection schemes.
If the BBB corporate bonds can survive this, perhaps the risks have been over-played. The BBB corporate bond segment is extremely diverse by business type and name. And while there will always been downgrades, more in tough economic conditions, the probability of it swamping the high yield market and causing vast value destruction remains, in our considered view, remote.
Stephen Snowden is manager of the Artemis Corporate Bond fund. The views expressed above are his own and should not be taken as investment advice.