Companies’ debt can fall fast when external events, or sector-specific issues impact ability to repay.
One of the key areas to watch in 2019 within financial markets could be corporate credit. With emerging concerns that the U.S. economy could be in the late stages of the current expansion, investors in corporate fixed income may likely do well by taking a company by company approach to where they choose to put their money to work.
“Over the next 12 months, we expect volatility to remain elevated and we see risks that credit spreads will widen even further,” says Collin Martin, fixed income strategist with the Schwab Center for Financial Research, writing in a December 18 Insights & Ideas piece. “While investors don’t need to abandon their corporate fixed income holdings, we think a more defensive approach is warranted, and that investors should consider moving up in quality.” 1
A growing concern within investment-grade corporate debt is the amount of leverage companies have taken on in the past decade along with the rising percentage of debt that is rated triple-B, just above that of below investment-grade or junk status. (The triple-B universe includes bonds rated BBB+, BBB and BBB- by the major rating agencies, such as Standard & Poor’s and Fitch Ratings with BBB- being the lowest; Moody’s Investors Service assigns Baa1, Baa2 and Baa3 to these bonds.)
Among the concerns is that, if the economy were to head toward a recession, there could be a greater risk that more investment-grade bonds could be downgraded to junk status. The perils of sectors within the corporate credit markets being negatively impacted by hard economic times isn’t the only risk investors face that their bonds may fall in value due to a ratings downgrade. Company-specific issues can also lead to a swift downfall.
The January 14 announcement by California’s PG&E Corp. that it plans to reorganize through Chapter 11 bankruptcy protection before the end of this month is just one such example. PG&E, which faces more than $30 billion in potential liability costs related to the 2017 and 2018 Northern California wildfires, had been rated within the triple-B spectrum by the major rating agencies until earlier this month when word that the company was considering bankruptcy came to light. PG&E has about $22.0 billion in outstanding debt and preferred securities, according to Fitch Ratings. 2,3
PG&E Corp. is among a handful of companies that have declared bankruptcy over a short period of time. While the bankruptcy filing of Sears Holdings Corp. this past October came after years of losses, the pace to a bankruptcy filing was quicker for Toys “R” Us Inc., which filed in September 2017, after key vendors tightened credit terms and stopped shipping products to the retailer just prior to the start of the holiday season. As this Bloomberg report points out, a similar fate befell American Tire Distributors Inc., which filed for bankruptcy over the course of six months following the loss of key suppliers.
In this environment, taking stock of the risks within individual company bonds becomes increasingly important. “Over the next six to 12 months, what I don’t own is just as important as what I do,” Jennifer Hartviksen, senior portfolio manager for global high yield at Invesco, told Bloomberg news. 4
Degrading Investment Grade Market, or Individual Issuer Driven?
It’s estimated that the triple-B-rated universe has grown to about $2.5 trillion outstanding as of 2017, up from about $950 billion in 2010. According to figures from a December report from Columbia Threadneedle Investments, this represents about 2.4 times growth for debt in this segment of the market tracked by the Bloomberg Barclays Investment Grade Corporate Index, compared to 1.9 times growth in outstanding debt for the entire investment-grade universe.
Those market participants open to holding opposing ideas about the dangers lurking in the triple-B rated bond universe can take some pause from Columbia Threadneedle Investments’ report, which seeks to illustrate that the alarms being raised around investment grade leverage and triple-B rated debt outstanding are oversimplifications.
“Neither the credit strength of individual firms, nor the market in total, can be simplified down to one or two financial metrics. Rather, it is a mosaic resulting from numerous financial health measurements,” Columbia Threadneedle Investments says. 5
For example, based on the 2017 data, nearly 90% of the growth from 2010 through 2017 in triple-B rated debt can be attributed to banking issuers and a “handful” of nonfinancial borrowers, including AT&T and Verizon (funding acquisitions), and Ford and General Motors (high-yield companies that were upgraded to investment-grade during the period, each representing about 7% of the growth in triple-B-rated debt outstanding).
“Investors can, and should, evaluate—at the issuer level—the downgrade risk that economic and credit downturns pose to each of these issuers,” Columbia Threadneedle Investments says. “One must also weigh each issuer’s ability and willingness to react dynamically to changes in its business environment in a manner that maintains its investment grade credit profile.”
The case can also be made that the aggregate amount of outstanding triple-B-rated debt is a cause for concern when investors put their money in bond funds and ETFs which track indexes like the Bloomberg Barclays Investment Grade Corporate Index. As Schwab’s Collin Martin notes, “investment-grade corporate bond investors may be taking on more credit risk than they’d like if they are in funds or strategies that passively track an index.”
In a grim scenario, a large number of downgrades to the high-yield universe could also lead to much less liquidity, since that market is roughly half the size of the triple-B universe. “By nature, the high-yield market has a much smaller investor base than investment-grade corporate bonds, so if a large amount of BBB-rated bonds get downgraded to the high-yield market, that increase in supply could send prices even lower,” Martin writes in the December 18 Insights & Ideas piece.
1 Martin, C. (2018, December 18). 2019 Credit Outlook: Time to Play Defense. Schwab Center for Financial Research. Retrieved from: https://www.schwab.com/resource-center/insights/content/2019-corporate-credit-outlook-time-to-play-defense
2 PG&E Corp. (2019, January 14). PG&E Remains Committed to Providing Safe Natural Gas and Electric Service to Customers as it Prepares to Initiate Voluntary Reorganization Cases Under Chapter 11 [Press release]. Retrieved from: https://www.pge.com/en/about/newsroom/newsdetails/index.page?title=20190114_pge_remains_committed_to_providing_safe_natural_gas_and_electric_service_to_customers_as_it_prepares_to_initiate_voluntary_reorganization_cases_under_chapter_11
(Information about PG&E’s estimates for potential liability for the 2017 and 2018 Northern California wildfires can be found here: https://www.sec.gov/Archives/edgar/data/75488/000095015719000032/form8k.htm)
3 Fitch Ratings. (2019, January 14). Fitch Downgrades PG&E Corp and Sub IDRs to ‘C’ [Press release]. Retrieved from: https://www.fitchratings.com/site/pr/10059365
4 Smith, M. (2019, January 14). PG&E Follows Toys ‘R’ Us and American Tire in Failing Fast. Bloomberg. Retrieved from: https://www.bloomberg.com/news/articles/2019-01-14/pg-e-follows-toys-r-us-and-american-tire-in-failing-fast
5 Doubek, T., Rinehart, S. and Agrawal, A. (2018, December). Triple-B Rated Bonds ─Should We Be Worried. Columbia Threadneedle Investments. Retrieved from: https://www.columbiathreadneedleus.com/content/columbia/pdf/BBB_BONDS_AND_LEVERAGE_11_18.PDF
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