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A bifurcation across investment grade credit

| November 16, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Investment grade credit spreads have jumped wider, led by an under-performance of ‘BBB’ rated debt. After hitting historical tights early this year, the level of spreads are back to those of late 2016 to early 2017. The momentum of the move clearly caught some investors off-sides, and there could be moderate follow-through in coming weeks. A bifurcation across ratings categories is already evident and could increase, as ‘BBB’ rated entities with heavy debt loads and lower growth opportunities absorb the brunt of the sell-off.

A sharp move wider

The investment grade corporate credit universe is now roughly one-half ‘BBB’-rated debt. The liquid investment grade universe – bonds with a minimum issue size of $500 million and at least three years to maturity – mimic the broader market as illustrated by the breakdown of the liquid investment grade market across ratings categories (shown in Exhibit 1).

Exhibit 1: IG credit spreads by Moody’s rating category

Source: BlackRock iShares, Bloomberg, Amherst Pierpont Securities; Note: Indices are constructed from bonds in as represented in the BlackRock iShares exchange traded fund LQD. Market values  are based on par amounts in the LQD index and are as of close 11/15/2016. The credit spread is calculated as the market value weighted spread to the Treasury curve, or g-spread. The yield and maturity are also market value weighted averages. Complete inclusion criteria for the LQD index is available on the iShares website. There are also some cash and money market holdings in LQD which is why the index weights don’t sum to 100%.

A small subset of bonds in the index are rated high yield by Moodys, but those typically retain investment grade ratings from either S&P or Fitch. Not surprisingly, the market is ahead of the ratings agencies, and those bonds straddling investment grade and high yield have materially wider spreads – 230 bp on average versus 173 bp for Baa. A recent history of the credit spreads across ratings categories (shown in Exhibits 2 and 3) indicates that although all ratings categories have experienced spread widening on a nominal basis this year, there has been an acceleration in the gap between A-rated and Baa-rated debt over the last few weeks.

Exhibit 2: One-year history of credit spreads across ratings categories

Source: BlackRock iShares, Bloomberg, Amherst Pierpont Securities. Note: Credit indices are constructed from bonds in the LQD index, as a market value weighted average of the g-spread from Bloomberg. Any bond with less than 90 days of spread history is not used.

The sharp move wider in recent days is consistent across ratings categories, but the difference in Aa and A-rated bonds has not changed; the widening in Baa-rated debt has been quite sharp.

Exhibit 3: One-year history of credit spread changes between ratings categories

Source: BlackRock iShares, Bloomberg, Amherst Pierpont Securities.

Leverage and momentum

The push wider over the last several weeks – exacerbated over the last few days – was punctuated by weakness in two heavily indebted Baa names: Ford and GE. This has led to some contagion risk across other highly levered names which face structural business challenges and are struggling to reduce their debt loads. None of this volatility is based on current economic weakness. There are legitimate fears that there could be a waterfall of downgrades from investment grade to high yield should the economy stumble into a recession, but this does not appear to be an imminent danger. High levels of leverage leave any balance sheet with less room to maneuver. For now, many highly leveraged companies hope to earn their way out of the problem and reduce leverage through profitability. Slowing growth could force companies instead to reduce share buybacks or cut dividends in order to deleverage. Debt spreads may continue to widen until the market sees clear evidence that management is willing to put debtholders ahead of shareholders.

Momentum is not a trivial force in the markets, and the re-pricing of credit may broaden to other vulnerable Baa names. Over time larger spread gaps could develop between names and rating categories as investors discriminate among the idiosyncratic risks embedded in particular corporations and business models.

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