When S&P Global Ratings decided to slash its rating of California-based utility PG&E by five notches at the beginning of this year it provided another painful reminder of just how fast corporates can move from investment grade to fallen angel to, in this case, failing angel.
The company announced its intention to file for Chapter 11 bankruptcy protection just days later on January 14.
PG&E, which has $18 billion of bonds outstanding and has been hit by a wave of wildfire liabilities that could reach $30 billion, previously filed for Chapter 11 in 2001.
The idiosyncratic nature of the risk it represents has not so far stoked too much simmering fear in the market over the looming triple-B cliff: the huge volume of lowest-rated investment-grade debt that will likely be cut to junk when the cycle turns.
That risk, however, is very much there.
|Justin Bourgette, |
According to Scope Ratings, in 2011 the single-A and triple-B parts of the US investment-grade market both accounted for around 25% of the total outstanding. In 2018, this has moved to a split of 20% and 35% respectively.
“For the last five years US corporates have geared their balance sheet to be triple-B: They have been encouraged to buy back stock to push earnings growth and have borrowed a lot of money in order to do that,” says Symon Drake-Brockman, managing partner at Pemberton Asset Management in London. “The market will be shocked by recovery rates during this cycle, due to a lack on lender protection in the documents.”
According to Scope Ratings, US non-financial corporate debt hit 73.2% of GDP in 2017, exceeding 2008 levels of 72.5% of GDP. In Europe, non-financial corporate debt outstanding has, however, fallen over the last decade, standing at 90.8% of GDP in 2017, down from the high of 102.8% in 2008.
Both numbers should be seen in the context of an even bigger problem: Chinese non-financial corporate debt has increased from 86.6% of GDP in 2007 to 157.4% of GDP in 2017.
“The risk presented by fallen angels and zombies is real,” says John Opie, associate director at Scope Ratings. “An estimated record $4.3 trillion in lower-quality corporate loans and high-yield bonds (up from $2.4 trillion in 2010) would face significant challenges if interest rates in the US increase sharply and the US economy deteriorates. This represents a systemic risk, and one that increases as standards deteriorate and covenants loosen in order to expand lending.”
Many disagree, and believe that noise around the triple-B cliff risk is a distraction. "I am more worried about single As than triple Bs,” Matt King, global head of credit products strategy at Citi tells Euromoney. “Only 15% of triple Bs are rated minus, with negative outlook, and most investment grade investors now have a high yield bucket of about 10% anyway. There are many more single-As that are rated minus, and lots of investors that have moved from government securities into investment grade corporates can only buy to single-A so if these securities are downgraded to triple-B they will become forced sellers,” he explains. “I am slightly more worried about European triple Bs than US triple Bs simply because the risk is less priced in, but the market coped when issuers rated at that level were downgraded, so unless there is a downgrade of a really large capital structure or of a large sovereign like Italy, then we think the BBB story is overdone."
Myles Bradshaw, head of the global aggregate fixed income fund at Amundi in London, also sees the concern as overblown.
“Corporate debt is the biggest concern - that is what the Fed wants to tackle. But the data is not flashing amber like the market is,” he believes. “We have seen a fall in the credit quality of the corporate bond market because corporates are using more debt and there has been a big growth in investors willing and able to buy credit.”
Concern over the triple-B cliff has certainly been heightened by the dramatic sell-off in high yield at the end of last year.
“When you get a sell off that is sharp and violent then either there is something wrong in the market itself and it needs to reprice or the market is just reacting to what is going on in equities," says Graham Neilson, investment director at Fulcrum Asset Management, which was set up by a team of Goldman Sachs alumni in 2004 and is chaired by ex-BBC head Gavyn Davies. “I think the recent sell-off is an example of the latter, but there is still structural risk.
“The triple-B cliff is one of many signs out there that the credit market, particularly in the US, is very late cycle,” he says. “In and of itself it doesn’t create a problem – there are other issues that in a tougher liquidity environment can create problems, such as laxer covenants and the size of the single-B pot.”
The largest industry group in the triple-B space is banks. So, if there was a lot of stress in this part of the market, it would, as Glenn Reynolds, co-founder at CreditSights explains, be game over in risky assets at that point.
“To be clear, we don't see that unfolding,” he emphasises. “That would harken back to 2008 and is a very extreme scenario.”
Drake-Brockman asks: “With regard to the triple-B cliff: Is the risk the value of the debt or is it the risk of default? You have a $2.7 trillion market that is four times larger than it was in 2007. We will have a lot of fallen angels.”
The key question is the high yield market’s ability to absorb them. Bradshaw at Amundi does not see this as a problem.
“The triple-B cliff is not something that I am worried about,” he says. “The macro outlook is stable growth, and I am not expecting a sharp increase in interest rates. If you were to have a big cascade of fallen angels, it would be a buying opportunity for us. There hasn’t been much supply in high yield though and I am not anticipating it.”
Default rates will be key.
“Defaults occur when the refi possibility gets worse,” says Neilson. “This is typically idiosyncratic to the corporate or affects one particular sector. But if the market is very concentrated in one sector (as it is in tech now and was in energy in 2015) and the refi price goes up, then that can be a problem for the whole market,” he says, while emphasising that his overall view of the space remains positive.
“It is hard to make money by having a very negative view of this market over the long run,” he points out. “If we are negative in this area, we can simply avoid it, trade the index tactically and think about the ramifications for other areas of the macro landscape.”