Issuance: Down but not out
The huge growth of BBB-rated credits in the investment-grade sector has raised some concern but there are opportunities for investors
- Issuance looks healthy despite the end of net new purchases by the European Central Bank
- BBB has become the dominant part of the investment grade universe
- There are concerns about the volume of debt that could be downgraded in the event of an economic downturn
- The high-yield market is unlikely to suffer as a result of an influx of fallen angels
“If you can borrow for 15 years at a funding cost of 0.5% a year why wouldn’t anyone do it?” asks April LaRusse, fixed-income product specialist at Insight Investment.
With 15-year German Bund yields at 0.5%, it is true that high-rated European issuers have had an unprecedented opportunity over the past few years to issue debt at historically low levels. There has been plenty of issuance, helped by the European Central Bank (ECB) asset purchase programme, although it ended net purchases in December. In the US, which also saw yields and spread compression at an all-time low in 2018, debt issuance was used aggressively to finance M&A transactions as well as share buybacks and dividend payments.
While Europe saw some of this at the end of 2017 and during 2018, in general, these proceeds were used more cautiously, says Henrietta Pacquement, head of European investment grade credit at Wells Fargo Asset Management. “European companies, particularly BBB-rated credits, have focused on looking after their balance sheets after the sovereign debt crisis of 2011-12,” she says. “There has been more aggressive behaviour by single A-rated credits like Bayer and Sanofi which have more scope to lever up to fund acquisitions.”
This year looks likely to follow 2018’s healthy issuance of European debt of €600bn with an even higher figure. The big issuers will be the banks, says Pacquement, as the ECB’s programme of targeted longer-term refinancing operations (TLTROs) instituted from 2014 start to mature and refinancing is required. The banking sector is also under pressure to increase loss-absorbing capital on their balance sheets which can be achieved through issuing investment-grade preferred senior debt in many cases.
Last year there were several reports highlighting the growth and increasing dominance of BBB-rated credits in the investment-grade universe, particularly after the global financial crisis. The growth in the US was pronounced, with BBB accounting for 48% of the investment-grade universe in 2000 and 58% at the end of 2018.
In Europe, the growth was spectacular, moving from 22% of the market in 2000 to 57% in 2018. The BBB portion of the investment-grade universe now dwarfs the global high-yield market (see figure). The fear is that in the next economic downturn, if the same percentage of investment-grade bonds becomes downgraded to high-yield (fallen angels) – as would be expected at the end of a credit cycle – then the $150-200bn (€131-174bn) or so that would represent could be far higher than the high-yield market would be able to absorb without significant disruption.
Investors with strategies that follow benchmarks closely will inevitably find themselves with higher weightings to BBB-rated credits. In addition, says Pierre Verlé, head of credit at Carmignac, rating agencies have been more lenient towards investment-grade issuers which are releveraging themselves for large acquisitions. Agencies have given such issuers the benefit of the doubt for future synergies and cost cutting. This, he argues, results in not only a bigger BBB market than during the last cycle, but also a weaker one.
Should investors be concerned? “It is only a problem because investors think it is a problem as they would prefer A or AA-rated credits to be at the centre of the investment-grade universe,” says Insight Investment’s LaRusse.
Indeed, Payden & Rygel (P&R)finds many more attractive opportunities in the BBB universe. Debt has been so cheap for investment-grade companies in the past few years that it has made sense for them to push their capital structures to the edge of investment grade, says P&R’s global credit manager Tim Crawmer. The firm is, however, incentivised to remain within the investment-grade universe because a move to high-yield would be punitive.
“Once a company moves downwards temporarily as a result of an acquisition, a share-repurchase programme or dividend, that is when we buy the BBB-rated bonds. We know the company management would be incentivised to use their free cashflow to delever”
“So once a company moves downwards temporarily as a result of an acquisition, a share-repurchase programme or dividend, that is when we buy the BBB-rated bonds. We know the company management would be incentivised to use their free cashflow to delever,” Crawmer says. The risk is that a bad timing for an acquisition could mean the firm ends up without enough free cashflow to delever, and so its cost of borrowing could go up through a downgrade. “But even here, though, often even when companies like these get downgraded to high yield, they move back up again,” Crawmer says.
Generalisations about the BBB universe can also be misleading, argues David Torchia, a portfolio manager at Stone Harbor Investment Partners. “It is important to drill down into the BBB segment and understand the dynamics of what is there,” he says. The growth of the BBB universe has not just come from new issuance by traditional BBB-rated companies but also through the migration of higher-rated companies as leverage levels have crept up in investment grade-rated companies over the past decade.
The current BBB universe has many more large-cap companies than has historically been the case. That, says Torchia, is significant because large-cap companies have large balance sheets, strong financial expertise and credibility. They are, therefore, the types of companies that are able to take the risk of hovering on the cliff edge of the investment-grade universe better than smaller-cap companies.
AT&T is a good examp le of firm that had been a bellwether single A-rated name but is now BBB as a result of an acquisition spree undertaken over several years. “AT&T’s downgrade has inflated the statistics of the BBB universe but has the financial strength and flexibility to give investors confidence that there would be no further downgrades,” Torchia says.
There are two main reasons why the high-yield market is unlikely to be disrupted through an influx of fallen angels from the BBB universe. First, as Torchia points out, on a relative basis, BBB-, the lowest rated segment of the BBB sector has not grown nearly as much as the upper strata of BBB-rated credits.
Second, what also matters is which industry sectors are likely to face pressures and lead any credit downturn. In 2001-02, the technology and telecom companies led the credit market down; in 2008, it was the financials; and in 2014-15 it was the energy sector. One thing common to sectors such as technology, telecoms and energy is, points out Torchia, they are all examples of higher-beta sectors with volatile business mixes and therefore more vulnerable to credit downgrades.
Currently, however, the companies that are most vulnerable through increased leverage are food and beverage companies and consumer product companies. These have levered themselves up, bought back a lot of stock and weakened their profiles, but they do not have businesses that are highly volatile. “These are businesses that investors would gravitate to in an economic downturn as a shelter,” says Torchia. “In a downturn we do not see them leading the market down through a contagion effect unlike, say, telecoms which did.”