Attack of the Killer BBB/BBs

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Attack of the Killer BBB/BBs

Over the last few months we have been highlighting US corporate bond spreads over Treasuries as financial markets-based recession indicators. These tend to spike ahead of economic slowdowns as fixed income investors start to discount weaker cash flows.

Two points on that topic today:

#1: Using BBB corporate bonds as the “weakest link” of corporate America’s balance sheets, there’s still not much reason to worry:

  • Current BBB spreads are 149 basis points over Treasuries. That’s down from January 2019’s peak of 206 basis points and basically the same as October 2018’s average of 148 basis points.
  • Past end-of-cycle periods always saw large upticks in BBB spreads. They went from 155bp in January 2000 to 268 bp in December 2000 (113 bp increase). In 2007 they started the year at 119 bp; by December they were 243 bp (124 bp increase).
  • Important: over half (50.6%) of all US investment grade corporate bonds are rated BBB right now, the highest percentage ever. Back in 2001, it was only 17%. BBB debt has grown in the past decade by 2.5x to $2.5 trillion. Most of that ($1.2 trillion) was net issuance, with $745 billion of downgrades. (Link at the end of this section with more color.)

Here is the chart of BBB spreads back to 1997 that shows these data points:

#2: To expand on this theme, let’s look at the historical difference between BBB and BB spreads. Here’s why this is important:

  • BB bonds may be the highest quality junk bonds, but they’re still just the best house in a rough neighborhood.
  • Non-investment grade bond investors tend to be less complacent than their high-grade counterparts and are especially more attuned to recession risk. In my +30 years on the Street I have never met a more cautious set of analysts than those that cover high yield securities.

Here is a chart comparing monthly average BB to BBB yields back to 1997:

This is what we see in the data:

  • The average BB – BBB spread from 1997 to present is 164 basis points.
  • As with BBB spreads, these tend to widen ahead of recessions. From January to December 2000 they increased by 62 basis points. In 2007, BB – BBB spreads widened by 130 bp over the course of the year.
  • Current BB – BBB spreads sit at 74 bp (BB: 223 bp, BBB: 149 bp).

The surprising conclusion is that even this marginal slice of the US corporate junk market shows little concern regarding an imminent recession:

  • BB spreads over BBB are well below long-run averages.
  • The only times this spread shows similar tightness is March 2005 and the first half of 2007.
  • As the chart clearly shows, there is no move higher for BB spreads underway right now. Not pictured but worth mentioning: the current 74 basis points is lower than October 1st (81 bp) and even with a month ago (73 bp).

Summing up with a bullish and bearish macro case for both datasets:

  • The upside is pretty obvious: corporate bond markets see little chance of a US recession or even a meaningful probability of weaker corporate cash flows in the near future.
  • The bearish argument is that ultra-low interest rates have permanently skewed corporate bond payouts to the downside as asset owners reach for yield. That limits their predictive power and sets up a pretty large cliff for these assets when recession does hit.
  • Also worth noting: the Wall Street Journal recently ran an article highlighting how ratings agencies have been giving remarkable leeway to BBB companies, a sentiment echoed by several investment banks of late. Link below – it’s a worthwhile read if you have not seen it.

The way we see it, both views have some truth to them, but markets clearly believe the former so that’s the narrative to follow for now. If the bears are right, the BBB/BB market will still send a recession signal when it wakes up to that risk. Yes, it will be a concurrent rather than leading indicator. But for now the corporate bond market shows little sign of trouble ahead.

Sources:

Blackrock blog item on BBB market: https://www.blackrockblog.com/2019/10/07/how-risky-are-bbb-bonds/

WSJ Article on ratings agencies: https://www.wsj.com/articles/bond-ratings-firms-go-easy-on-some-heavily-indebted-companies-11571563801