Following the financial crisis in 2008, a policy of quantitative easing flooded lending markets with capital, presenting corporates with the opportunity to take advantage of cheap debt and lower lending standards—all with the goal of pulling the global economies out of the gutter. Corporates jumped at the opportunity, and during this period, the bond market grew by 37% to more than $6 trillion USD.
More notably, the pool of lowest rated investment grade bonds tripled (i.e., BBB & Baa) to more than $3 trillion USD, outpacing all other bonds, including the pool of highest rated speculative grade bonds (i.e., BB &Ba).
Historical BB and BB FV ($ mn)
Approximately 50% of all investment grade bonds trading in the US are rated BBB or Baa. While that percentage drops to 25% for all Canadian corporate bond issuances trading in the US, it still represents a large class.
Unlike stocks, corporate bonds are rated by large, multi-national ratings agencies such as Moody’s and Standards & Poor’s (“S&P”) to assess the credit risk of issuances. In general, ratings can be categorized as investment grade or speculative grade. Ratings dictate the interest coupon of each new issuance and limit the scope of potential investors to those with appropriate risk appetite. A significant portion of corporate bonds are purchased by institutional investors (i.e., financial institutions, university endowment funds, etc.), many of whom face restrictions concerning the quantum of speculative grade assets which can be held.
As a result, the speculative grade market is merely one third of the size of the investment grade market. But that all could change. As credit risk changes, issuances and issuers are reviewed by ratings agencies to determine if a rating change is required. Upgrades and downgrades, in aggregate, tend to vary with economic activity and stages of the credit cycle.
An unknown future for the corporate bond market
While we’ve seen as many upgrades as downgrades in recent years with strong economic growth, a potential inflection point in our economy could threaten to catapult this market.
Nearly half of all investment grade bonds are BBB/Baa.
We’re seeing economic disruptions like global trade tensions and geopolitical turmoil on a daily basis. However, for North America, we’ve yet to see a catalyst event drive an economic slowdown. Paradoxically, we’re continuing to see the opposite; the S&P 500 recently marked the longest bull market in its history. But a downturn is ultimately inevitable, and some economists believe it will happen in the next few years. As per the late economist Allan Meltzer, Professor of Political Economy at Carnegie Mellon University Tepper School of Business, “capitalism without failure is like religion without sin.”
“Capitalism without failure is like religion without sin.”
Any slowdown in global growth could quickly erode the credit ratings of susceptible borrowers populating the BBB / Baa bench. Issuers with BBB / Baa rated bonds are sitting in a precarious position; while any downgrade is bad news, those bonds rated BBB / Baa are guaranteed to fall from investment, to speculative grade, with any downgrade. A shift from investment grade to what is colloquially known as junk, or high-yield, may present a host of difficulties for issuers:
- Cross default provisions on active or standby financing facilities may be triggered;
- Refinancings (or the rolling over of series) will almost certainly become more expensive, if not impossible;
- Corporations previously enjoying the highs of a low-cost economic environment may find themselves having to batten the hatches; and
- M&A activity and capital spending are most likely to be impacted in the short term, creating a trickle-down effect for those industries and companies who service and support the issuers.
While the market’s appetite for high-yield, speculative grade, covenant light assets continues to be voracious, it’s important to understand what impacts a downgrade could have on your business.