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The explosive growth of BBB credit
The growth of BBB credit in the decade following the global financial crisis has been a source of angst and hand-wringing amongst many market commentators. Many have questioned whether BBBs present a systemic risk and whether they have a place in a fixed-income portfolio.
While global credit markets have doubled to $10 trillion over the last decade, BBBs have increased five-fold and now represent around 50 per cent of the total market capitalisation. At the same time, BBB-rated companies today are more levered than they were 10 years ago. The rating agency justification for this, often told, is that low interest rates and high profit margins mean the debt is perfectly affordable.
Source: Fidelity International, January 2019.
Furthermore, so the argument goes, the BBB cohort has become dominated by more defensive sectors such as consumer staples and healthcare, after a purge of some cyclical names during the 2014-16 commodity cycle. These companies are typically more resilient to the economic cycle and have a portfolio of cash generative assets that can be monetised even in a difficult economic environment.
Here’s the rub. As we saw in 2016 with commodity names, a revision of base-case assumptions by the rating agencies can result in sector-wide credit downgrades. The list of potential catalysts for such a revision is long and includes trade wars, wage inflation, and changing consumer tastes. But they all boil down to slowing growth and mean reversion of astronomically high margins. Agency assumptions on the deleveraging of large post-M&A capital structures are already coming under scrutiny following some high-profile profit warnings and delayed debt reduction.
While we struggle to see how the BBB market itself will cause a turn in the global economic or credit cycle, we do recognise that it may be a source of pain when risk markets crack.
However, you ignore BBBs at your peril. The 10-year cumulative outperformance of GBP BBBs over single-As is 48 per cent and there have only been five years of BBBs underperforming single-As since 1996. None of the years were concurrent, and, yes, 2018 was one. Simply put, the yield advantage of BBBs is a tide that is hard to swim against.
In sterling, the weighting of M&A-fuelled BBBs, consumer and healthcare, is lower with a greater emphasis on utilities and real estate. Neither sector is without its challenges, but the froth of the US consumer names is notably absent.
Mindful of risk, our focus is on businesses with stable cash flows and solid asset backing. Asset-backed securities, real estate and utilities offer both characteristics and come with the robust covenant and security packages that are missing from straight corporate debt. There is a time for cyclical BBBs but late in the cycle is not it.