How does the 2020 downturn compare with the 2008 credit crisis?
Through the first two quarters of 2020, the par amount of IG bonds downgraded from investment to sub-investment grade has already exceeded the total recorded during the entire two years of the 2008–2009 financial crisis by $9 billion. While $139 billion is a record in dollar volume terms, due to the substantial growth in the market it represents only 2.6% of all outstanding investment-grade bonds, far below the 4.2% downgrade rate in 2008.
The current recession is fundamentally different from the 2008 credit crisis, when financials were at the epicenter. Counterparty risk led to contagion concerns, particularly following the defaults of Lehman and Washington Mutual. The subsequent implementation of more stringent regulation has left banks entering the current downturn with nearly double the capital ratio they had in 2008. They’re now in a stronger position to absorb losses, mitigating both downgrade and contagion fears. No 2020 fallen angel has defaulted so far, and almost all remain in the BB rating category.
How much more investment-grade debt is at risk of being downgraded?
With nearly 50% of the investment-grade market falling into the BBB rating bucket, the potential for downgrades continues to receive a lot of attention. We’ve seen forecasts for the total amount of fallen-angel debt this credit cycle ranging from $175 billion to $600 billion, with higher estimates including emerging market debt, such as the $58 billion issued by Mexico’s national oil company, Pemex, which was downgraded to high yield in April.
The pace of the downgrades has already lessened considerably over the last two months. As the second-quarter earnings season progresses, rating agencies will get a better understanding of the current state of credit fundamentals. Should the results beat expectations or indicate an upward trend, ratings agencies are more likely to view the current weakness as temporary and adopt a wait-and-see attitude.
At the end of June, companies whose debt traded above the average spread for BB-rated bonds had $30 billion par outstanding. We estimate that $80 billion of IG bonds are currently rated BBB- with a negative outlook such that a downgrade by just one agency would push them out of the IG index. These figures would be consistent with fallen angels totaling about $200 billion this cycle.
Which factors support the investment-grade market going forward?
Drawing on their experience during the 2008 credit crisis, the Federal Reserve intervened quickly and aggressively in March 2020 as the pandemic worsened and financial markets sank. Their decision to include IG bonds in this round of their quantitative easing program stabilized the market and led to a historic rally. The Fed recently finalized the terms of their primary credit facility, which will allow IG companies that have trouble accessing markets to borrow from them directly, thus helping to contain interest costs should spreads widen again. Future fallen-angel companies are eligible for these programs as well.
Companies have considerably improved their liquidity positions to see them through this recession. Issuance in the first half of 2020 exceeded annual issuance in most prior years. Proceeds are being used to build cash reserves and buttress balance sheets. Companies are also cutting costs, reducing stock buybacks, and trimming capital expenditures in order to maintain their investment-grade ratings.
Finally, the economy is recovering much more quickly than the consensus forecasted. Employment is consistently surprising to the upside, manufacturing indexes are improving, and fiscal programs have helped bolster the consumer. Clearly the progression of the COVID-19 virus will play an important role, but it appears that the near-complete shutdown of the economy in March and April is unlikely to be repeated. Furthermore, major oil-producing nations have agreed to production cuts, relieving the pressure on crude oil prices, which have recovered to $40 per barrel.
The bottom line
Despite the likelihood of continued downgrades, the trend in credit fundamentals makes IG bonds an attractive investment alternative. An improving economy, innovative Fed programs, and additional liquidity on corporate balance sheets suggest the worst of this downgrade cycle is probably already behind us, although the pandemic could easily change the trajectory of the current rebound. Expert fundamental research can be invaluable to IG investors in all market conditions, even now as the pace of downgrades slows from record levels.