In recent years, investors have expressed ongoing concern about the size and condition of the BBB component of the investment grade credit market. However, fundamentals continue to suggest that the worries, although real enough, are also manageable. Indeed, despite narrower spreads, we believe potential market turbulence could provide openings for select exposure. This is an update to our previously published views on BBBs (Read BBBs: Beyond the Headlines and U.S. BBB Corporate Risk: Flexibility in Focus).
BBBs Remain Significant But Fallen Angels Have Been Limited
BBB-rated bonds continue to represent roughly 50% of U.S. investment grade credit market, or $2.9 trillion in market value, mostly comprised of Industrial issuers. Despite widespread concern over a potential increase of “fallen angels” from BBB to high yield ratings, the supportive macroeconomic and earnings backdrop has actually limited such downgrades. During 2019, increases in BBB market value were largely driven by just a few companies engaged in leveraging M&A transactions. As we look further into 2020, our expectation is for additional modest growth in the BBB category tied to new entrants, due to M&A or idiosyncratic issues. However, we also expect to see progress on deleveraging from some of the largest BBB issuers, potentially improving credit metrics and helping credit ratings migrate upward in select, large BBB capital structures.
U.S. Corporate Credit: Market Value by Rating
Dollar Value, Percentage of Market
Source: Bloomberg Barclays, as of December 2019.
Fallen Angels - Par Value
Source: BAML. Bonds transitioning from U.S. Investment Grade Index into U.S. High Yield Index.
Fundamentals Continue to Improve
The leverage of BBB issuers has declined over the past three quarters from recent peak levels of more than 4.0x total debt/EBITDA, driven by both absolute debt reduction and EBITDA improvement. Free-cash-flow generation has turned positive as share repurchases have declined as a use of cash. Assuming our expectation for a supportive macroeconomic and earnings backdrop, we believe these trends will continue given that several of the largest BBB issuers are focused on deleveraging.
S&P500 ex-Financials BBB-rated: Total Debt / EBITDA
Source: Bloomberg. Data filtered by rating as adjusted by Neuberger Berman.
Specifically, looking at the top 10 BBB issuers that comprise over 20% of BBBs ex-Financials, we highlight that average leverage is down from recent peak levels. Within this group, several large issuers levered up to finance M&A and continue to use strong free-cash-flow generation to enable post-deal de-leveraging. For example, AT&T has decreased leverage over a turn from its peak to < 3.0x with absolute debt reduction of about $25 billion from peak levels. Verizon has been focused on deleveraging and using its robust free-cash-flow generation to improve its credit profile. Anheuser Busch InBev recently took substantial actions to monetize non-core assets to pay down debt, after being downgraded to BBB due to slower-than-expected deleveraging. We expect ratings for issuers such as Verizon and Anheuser Busch InBev to migrate upwards over time. The autos sector continues to be an outlier where we have less constructive views on the sector fundamentals with large issuers Ford and General Motors further constrained by the more cyclical nature of cash flow generation. While we are constructive on the midstream sector, it is an outlier in that companies in that sector are comfortable keeping BBB credit profiles with no explicit plans for debt reduction from large issuers such as Energy Transfer Partners.
Top 10 BBB Industrials - USD ($bn)
Source: Bloomberg Barclays, market value of index debt
BBB Spreads: Valuations Have Compressed, but Volatility Could Provide Opportunity
BBB spreads outperformed in 2019 following material widening in the fourth quarter of 2018. As valuations have compressed, it has made sense to reduce exposure accordingly. However, moving further into 2020, we still think there is opportunity across BBBs. In times of volatility, we would favor a tactical approach, taking opportunities to add to select issuers with improving fundamentals and dislocated valuations.
U.S. Credit vs. U.S. BBB: Option-Adjusted Spreads
Source: Bloomberg Barclays.
Be Selective in 2020
From a fundamental perspective, we maintain our view that the consensus has been too general in its assessment of BBBs, pointing to improving fundamentals and limited fallen angels over the past several years. Looking ahead, we believe that most investment grade issuers will not stand by idly as their credit profile deteriorates and ratings go lower. Assuming a slow but comfortably positive macroeconomic growth environment and continued accommodative monetary policy, we expect continued fundamental improvement, especially as some of the largest BBB capital structures focus on deleveraging and credit metric improvement. While we anticipate some entrants into the rating category as the result of M&A or idiosyncratic risks, we do not think the magnitude is concerning absent a deterioration in the macroeconomic forecast. However, what is different now versus a year ago is that valuations have compressed. Marrying fundamental and valuation frameworks in assessing BBB risks and opportunities will therefore be paramount to performance in 2020.