As we think about the outlook for 2023, we believe the global macro environment is setting up to be a return to the “old normal.” As discussed in the firm’s recent Solving for 2023 publication, this may involve troughs in GDP and corporate earnings growth amid structurally higher interest rates. Unlike in the post-Global Financial Crisis “new normal” environment, investors and enterprises are unlikely to see a Federal Reserve “put” that can bail them out of adversity. In this context, companies could find increasing demand from investors to generate value. A key question to us, therefore, is how BBB industrial credit—a large and important part of the investment grade credit market—may perform in this changing environment. In our view, overall starting fundamental conditions may be better than in past periods of market and economic stress, but the answer on BBBs may very well depend on individual credit dynamics.
Dominant Industrial BBB sectors have less cyclical cash flows and lower leverage versus historical periods.
As we have explored in previous periods of volatility when questions were raised about the viability of the Industrial BBB cohort, we continue to anchor our analysis in understanding the current sector composition of BBBs versus other periods in history. In 2003, consumer cyclical sectors including Autos made up just over a quarter of Industrial BBBs. Looking at BBB Industrials today, consumer cyclicals represent less than a 10% share. Growth has come from consumer non-cyclical, which is now just under a quarter of the total, driven by growth in the Healthcare and Pharma sectors, which are the largest BBB sectors outside of Telecom and Technology. While we believe certain risks warrant monitoring in Healthcare, specifically relating to newer, less-tested business models, we still would characterize the sector’s cash-flow characteristics as defensive, even in a downturn.
Given this shift, Industrial BBB cash-flow profiles in aggregate are less cyclical than in previous recessionary periods. In the early 2000s industrials-led recession, BBB Industrials were dominated by Autos and Telecom. Fallen angels in that period were concentrated in these two sectors following the dot.com bubble and in light of unique dynamics in the auto sector. The investment grade Telecom sector of the early 2000s was under threat as deregulation increased competition, capex levels were elevated as operators overestimated consumer growth targets and aggressive accounting practices increased financial risks. The investment grade Telecom sector today features more utility-like business models with more diverse and sticky cash-flow streams, and is not facing existential threat as the demand for digital services has proven structural.
Additionally, using the S&P 500 (ex-Financials) as a proxy, gross and net leverage of the BBB cohort is lower today than in the early 2000s period, and companies are entering the “old normal” with strong balance sheets, which recently endured the COVID shock. While leverage has room to increase as profitability comes down from recent peaks, it is starting from a healthy level.
The Changed BBB Industrial Landscape
Industry Weightings, 2003 vs. 2022
Source: Bloomberg Barclays Index Services. December 31, 2003 vs. December 30, 2022. Data as adjusted for accurate sector comparisons.
Debt maturity profiles have been termed out, although interest coverage will likely deteriorate as rates rise.
Over the past decade, companies have taken advantage of the low-interest-rate environment to term out debt maturity profiles at historically low, fixed rates. While interest coverage is expected to decline and the average coupon of Industrial BBBs will trend upwards going forward, we think that most companies will consider this in their capital allocation decisions and make adjustments as needed to maintain credit quality. Importantly, interest expense adjustment should not hit companies all at once, but likely over time as they have to refinance maturing debt. Over the past several years, liability management actions were widespread and resulted in lower refinancing risk in aggregate. We expect that activity to moderate going forward. Heading into this new environment, companies are likely to be less active in liability management exercises and mindful of new all-in coupon rates when making financing decisions. Looking at Industrials in aggregate, short-term debt has generally been termed out and long-term debt makes up a more meaningful portion of total debt. Within BBBs, sectors such as Autos and Healthcare have a higher portion of debt coming due as a share of each individual sector and warrant monitoring from a refinancing perspective, although auto companies are accustomed to this shorter-term financing structure and can plan accordingly.
BBB Companies Have Capitalized on Lower Rates
US Corporates BBB (ex-Financials) Coupon
Source: Bloomberg Barclays Index Services. Monthly data up to 12/30/22.
Certain business models could be exposed; a toolbox of mitigating actions may come to the forefront.
We have long reminded investors that not all BBBs are created equal and that, even within better-positioned sectors, there will be winners and losers. Companies with better business models, lower business risk, strong financial metrics and high-quality management teams should win out over those who have less business model agility, weakening credit metrics and weaker management teams. For example, we are incrementally concerned about the fundamentals of consumer cyclical BBBs, including smaller sectors such as Retail and Autos, in a weaker consumer-spending environment. Certain BBBs that have benefitted from COVID trends and managed through volatile supply chain issues are being caught with elevated inventories and engaging in aggressive markdown activity, threatening margins and weakening cash flows. Financial policy decisions during this transition period will be a key determinant of credit-quality trajectory, and we would emphasize that the speed at which management teams need to react must increase. Companies with higher-quality assets and more efficient operations will be sharply separated from weaker players. Management team quality will be tested, and better operators will quickly be distinguished from those that benefited from the “rising tides” of the past several years. As noted in Solving for 2023, when the tide goes out, you have less time to “grab your clothes” and we think that companies will need to be mindful of the time required for mitigating actions to kick in.
Fallen angels are likely to be manageable in size.
Periods of elevated fallen angels tend to happen around episodic events that take down certain sectors. Absent any sector-specific shocks, we think that, in an “old normal” environment, fallen angels could be in the low $100 billion range over the next year. Fallen-angel par value during COVID was just under $200 billion, and it has been muted in both 2021 and 2022. Among the current low-BBB rated sectors, Technology, Telecom and Cable/Media account for just under 40% of the market value of Industrial BBBs. Looking at the biggest sector, Technology, most of the low-BBB tech companies are well-positioned from a free-cash-flow perspective and, in aggregate, have conservative balance sheets. Fundamentally, we believe the longer-term secular growth story still holds due to the “electronification of everything” trend and enterprise digital transformation. While there are some individual issuer exceptions to this thesis, we think the sector in aggregate is not alarmingly at risk of widespread fallen angels. In Telecom and Cable/Media, we similarly expect continued positive fundamental momentum out of most issuers that benefit from strong free-cash-flow generation.
Top Sectors in Low-BBB Category (% Low-BBB Market Value)
BBBs are still incented to fight back but may face more push-back given competing interests.
In the “old normal” environment that we are describing, we still think that BBBs will be incented to fight back and defend credit profiles as needed. However, in an environment where there are increasing demands to generate shareholder value, certain decisions will be tougher. For example, decisions to moderate share buybacks in a depressed equity valuation environment may face harsher criticism from shareholders. Asset sales may be tougher to execute at attractive valuations. M&A might be more enticing in the face of slower organic growth and recent stock price weakness, despite the higher all-in cost of financing. However, the benefits of staying investment-grade rated likely still tip the balance in favor of measured behavior that maintains credit quality. The COVID-era emphasis on liquidity and the backstop provided by the Fed for investment grade issuers are still a recent memory. However, we do not expect the Fed to bail out investment grade companies in a prolonged, slower-growth period. In our view, prioritizing the balance sheet will be the norm, with deviations from that the exception.
BBBs remain attractive, but with a focus on credit selectivity.
The current differential between BBBs and single-As is just under 50 basis points—still below the five-year historical average. Of course, the all-in coupon rate that issuers are looking at now is much higher than it would have been in recent history. We did not see a swath of bad behavior heading into the recent hiking cycle as far as companies rushing to get acquisitions done or issuing debt in mass to fund share repurchases. As companies recalibrate their models to a structurally higher cost of debt, we still expect BBB to be an attractive capital structure on a relative basis. As such, we continue to have an attractive view of the market segment, although credit-picking will increase in importance as the “old normal” takes shape.
Still a ‘Sweet Spot’: BBB vs. Single-A Spreads