US corporates with Triple-B or investment grade (IG) credit rating, who have undertaken significant amount of mergers and acquisition (M&A) in 2018 by leveraging their balance sheets, are now facing the prospect of downgrades in their credit rating to Double-B or high yield (HY) bonds in the wake of the expected slowdown of the global economy in 2019.
The development is expected to result in some dislocation among institutional investors who are restricted to investing only in investment grade bonds, although there will also be investment opportunities for some asset managers.
"The move from investment grade to high yield will be a dislocation in the market because of the type of investors that are allowed to buy IG bonds. For us it's an opportunity to underweight those Triple-Bs, wait until they go to Double-Bs, but in that transition there will be a lot of pain and re-pricing in the market," says Malie Conway, managing director for global fixed income at Allianz Global Investors.
Conway explains that one of the biggest worries for investors in US corporate bond investors in 2019 is the increase in "idiosyncratic risk", also referred to as "unsystemic risk" or risk that has correlation to overall market risk.
"The reason for that is particularly in the US market there been a lot of Triple-B companies have undertaken significant amount of M&A activity and they have leveraged their balance sheets quite substantially. What they've done is they went to the rating agencies and they said yes, we know that we have leveraged our balance sheets but over the next 2-3 years we will de-leverage. So even though our matrix on a standalone basis, if you took a snapshot today is Double-B, over the next year or two we will de-leverage and we will go back to triple B credit matrixes," Conway says.
This means that although many US corporate bonds are still rated as investment grade and are still trading as Triple-B rated bonds, because their issuers have accumulated a lot debt, their credit rating has effectively become non-investment grade or Double-B based on the matrix of the credit rating agencies.
"So, assuming that you think the global economy is going to slow down, the probability of those companies de-leveraging is going down. Therefore, in our view they should be re-priced like Double-Bs. If we are right there will be a lot of downgrades from Triple-B to Double-B. As many people are aware, the amount of debt outstanding of these companies is significant. We believe that that has a lot of pressure on the high yield market and the IG market as these bonds re-price," Conway says.
"Because they can't de-leverage, they cannot deliver what they promised to the rating agencies and the market will start looking at these credits as Double-B. So, we think there will be substantial amounts of downgrades from IG to high yield into the market," Conway says.
BNP Paribas Asset Management senior investment strategist Daniel Morris, however, says: "Yes corporate debt levels are high but we don't think it's a problem yet. When we get closer to the recession then that's when the negative consequences of highly leveraged companies suffering from defaults and everything else will come. We just don't see that cycle starting yet."
