Cheap interest rates and receptive debt markets have helped triple-B rated corporate debt to balloon from $1tr in 2006-2007 to $2.6tr this year, according to S&P Global.
With the credit cycle grinding on, some high yield investors are weighing up the risks and opportunities that large scale downgrades might present as borrowers drop into the high yield market.
Some are hoping that a flood of triple-B rated bond downgrades might help reinvigorate a high yield market that has been leaking issuance to the leveraged loan market and investment grade bonds.
High yield volumes are down 28% year on year, according to JP Morgan researchers, with $132.2bn sold during the year to date. That includes a “paltry” $6.1bn in July — a month that has averaged $21bn of issuance since 2010.
That suggests there is plenty of unsatisfied demand that would welcome a boost of issuance.
“Companies previously downgraded have made their way back to investment grade and others are choosing to tap the bank loan market where capital is cheaper and demand is more consistent (thanks to the voracious appetite of CLO issuers),” wrote Michael Temple, director of US credit research at Amundi Pioneer.
Fallen angles might help “rehydrate” a desert dry high yield market, according to Temple. In addition, as companies are downgraded they will come under pressure to shore up their balance sheets instead of pursuing debt-fuelled growth strategies, improving the investment case for investors.
“For those who’ve been casting in the high yield market and coming up empty-handed, your net is about to become full,” he argued.
However, while Temple is hopeful that as much as $200bn-$350bn could be headed for a downgrade over the next several years, a report from S&P Global Ratings on Wednesday was less pessimistic.
It said that investor fears over triple-B bonds might be “overdone”.
Borrowers have enjoyed a long period of favourable borrowing conditions, and while firm said it expects rates to rise slowly in the next 12 months, "we don't foresee any sharp increases or a marked reduction in access to capital in the near term".
Median leverage remains low in the triple-B universe at 2.3 times, up from 1.9 times in 2008. The tax package passed earlier this year has given companies a cash flow boost, while the economic backdrop is strong, helping companies generate increases in free operating cash flow relative to debt. That metric improved for triple-B companies to 19% last year, up from around 17% in 2008.
That said, the S&P analysts noted that risks have increased in certain pockets of the triple-B market, particularly consumer product companies that have embarked on ambitious M&A activity to try to boost sluggish sales growth. But while the capital structures at such firms have weakened, the rating agency believes that those borrowers can reduce leverage over a two year window and maintain investment grade ratings.
Overall, S&P predicted that the proportion of ratings that would be downgraded from triple-B to double-B won’t deviate materially from historical averages of around 10% over a three year period during the next downturn.
As of July 9, the firm has flagged 28 triple-B rated companies that are considered potential fallen angels. Between them, they have around $90bn of outstanding debt. Both the number of potential fallen angels and their debt remain below the highs reached during stressed periods in 2009 and 2002, the analysts wrote.