Corporate bonds have benefited from extraordinary monetary policies. But as the probability of global recession rises, we worry that vulnerabilities within credit markets could disturb this relatively blissful environment for investors.
Our bottom-up analysis of the global investment grade market reveals $460 billion of bonds at risk of being downgraded to high yield if the economy turns to recession, thus becoming ‘fallen angels’.
This is a very high number compared to previous downturns (more than double that seen in 2009), mainly because credit markets have grown significantly since the global financial crisis. The majority of this growth has come from the lower quality end of the credit spectrum, so there is a higher proportion of debt already on the cusp of high yield than 10 years ago.
However, somewhat counter-intuitively, our analysis suggests a ‘best case scenario’ for credit markets – in which the economy holds up and quantitative easing continues – also poses a major risk to credit quality.
Low borrowing costs have encouraged the growth of debt-funded mergers and acquisitions, and companies have shown a willingness to take on higher leverage and sacrifice credit ratings. Crucially, bond markets – supported by quantitative easing and investors searching for yield – have not punished companies for this behaviour.
We have identified $360 billion of bonds that are already vulnerable. These have been issued by corporates whose leverage is elevated following M&A and for which debt reduction is required in order to preserve their investment grade ratings.
In addition, we estimate a further $120 billion could fall to high yield if buoyant market conditions encourage companies to sacrifice their credit ratings for a transformational transaction.
Whatever the market backdrop, we have to brace ourselves for the possibility that an unprecedented volume of bonds could fall into high yield over the coming years. In fact, we expect at least $100 billion of downgrades regardless of economic conditions and corporate actions.
Fallen angels may not face “bottomless perdition”, as the poet John Milton puts it, but a failure to absorb this debt would lead to a liquidity crisis for corporate borrowers. This would have significant repercussions for markets and the wider economy, while presenting opportunities to active investors.
This is an extract from our CIO Outlook.