The story it tells is clear and undeniable in its depiction of the lava-like, downhill flow and deterioration of investment grade (IG) corporate credit quality over the past 40-plus years.
As the title of this paper suggests, credit migration is probably worse than you think, but then not as bad as you fear. So how concerned should investors be about this phenomenon? Where should their focus lie?
Key questions investors should ask regarding credit migration include: Are investors being adequately compensated for the increased credit risk from downward ratings migration? Why is credit quality so downwardly biased? (See appendix.) How should they think about the structural trend and factor it into their investment strategies?
Credit quality migration can also have important implications for institutional investors in terms of how they think about portfolio construction and bond benchmarks.
The thoughts that follow highlight what we believe is driving credit migration, how likely it is to continue, and what investors can do about it.
Like economic cycles, there are credit cycles, and the two are often closely linked. We can observe this in terms of default rates, ratings upgrades and downgrades, and credit spreads.
The chart below shows the ratio of ratings downgrades to upgrades in the Barclays Global Credit Universe over the past 34 years. One can observe credit cycles coinciding with economic cycles, e.g., the early 1990s, the early 2000s (tech bubble burst), and the Global Financial Crisis of 2008/2009. Note that in the 34 years of data presented, the average ratio of downgrades to upgrades was 1.6x, and in only 11 of 34 years did the ratio fall below one (that is, fewer downgrades than upgrades).
However, in addition to these credit cycles, there has been a strong and structural credit migration—and that direction, as we’ve seen, is downward. This is the case for both individual issuers, as well as in the composition of the overall corporate debt market. Regarding the composition, new issuers with lower credit ratings can dilute the quality of the overall corporate debt market.
To get a better understanding of credit migration, let’s take a closer look at the lava chart at top. Compare the percentage of the index that was AA/AAA (“AA+”) in the early 1970s relative to A/Baa. In the early 1970s, more than 58% of the index was rated AA+, while Baa was less than 10%; today, only AA+ is 20% while Baa is 44%!
And most of that AA+ is not corporate debt, but rather taxable municipal bonds such as those issued by universities, hospitals, and certain museums such as the Metropolitan Museum of Art, along with quasi-governmental entities. Of course, the size and composition of the index has changed substantially. The index used to be dominated by utilities and a number of “blue chip” industrial names, including autos and phone companies, plus additional sectors such as railroads and several banks.
Actually, the index may also understate the credit ratings migration, due to survivor bias. This is introduced when issuers downgraded to High Yield (Ba1/BB+ or lower) fall out of the index.
The table below presents yet another dramatic picture of the remarkable change—decline —in credit quality. In 1988, there were 114 US issuers rated AAA, including Exxon, Johnson & Johnson, IBM, GE, Pfizer and Morgan Guaranty. Today, in 2016, there are only 13 US issuers rated AAA, with only two of them—Exxon and J&J—holdovers from 1988. Microsoft is the only other corporate issuer rated AAA; the rest are the universities, hospitals and quasi-governmental entities previously referenced.
As a proxy for credit quality volatility, we can use credit rating changes issued by the rating agencies. I believe while the rating agencies misrated subprime asset-backed securities (ABS) in the lead up to the Global Financial Crisis, they appear to have done a good job overall rating corporate credit, particularly as it relates to assessing risk of default. From an investment perspective, they tend to not do as well with less dramatic changes in credit quality, as the market often reprices credit well in advance of the rating agencies changing their ratings (both up and down).
The two ratings transition matrices below show the average credit rating migration rates, over three and ten years, for both global (developed markets—“DM”—and emerging markets —“EM”) and US-only markets, using 30 years of data-specific cohorts. The grey shaded percentages on the diagonals show how many of the issuers with a given rating at the start had the same rating three and ten years later.
The matrices show that credit quality is quite volatile—and downwardly biased!
Some key observations:
Worrisome as credit ratings migration may appear, we believe it’s really not as bad as you may fear. Let’s see why. In the chart below, note the cyclicality of the default rates since 1981. Historically, the default rates spike during times of US recession, as shown by the grey bars. Also, due to recent commodity price declines, default rates could be higher than normal in 2016.
If credit migration were consistently downward, then this would be shown in a steadily rising default rate over time. Instead, we see that credit experiences cycles, and in the aggregate, the downward migration seems to slow down, or even stop, at BBB or BB. It’s worth remembering that, despite negatively asymmetric ratings migration, default rates for IG and BB credits are still relatively modest over time. Similarly, high yield (HY) default rates are also cyclical.
In general, the market reprices either in advance of, or coincident to, changes in credit quality. As shown in the candle chart of global investment grade credit below, historically market returns have adjusted for higher credit risk over time. That is, the market has rewarded investors for greater expected credit risk. The lower the credit quality, the higher the potential excess returns and the greater the volatility and variability of those returns.
High yield (HY) is a more mixed story, with lower-quality credit (single B and CCC) providing lower cumulative total returns relative to higher quality credit (BB) over the past 20-plus years. However, over time, all three HY quality ratings categories have shown positive cumulative returns despite the negative ratings migration.
It’s worth noting that high yield tends to focus on total return, while investment grade focuses on excess return over default-risk-free government debt. This is because high yield can have a risk/return profile that is between equity and fixed income, while investment grade’s profile is more similar to fixed income.
So if credit quality can be expected to migrate downward in the future (see appendix), as has been the case in the past four decades, what can investors do about this, and how could it influence their investment strategies?
If it’s any consolation, the market anticipates and prices for downward quality/ratings migration, (except for CCCs and maybe single Bs), and issuers’ credit quality doesn’t continue to decline until default. Historically, a selloff of fallen-angel securities is often sharp but short-lived, with the worst performance often taking place during the initial month of downgrade.
Overall, credit market investors should bear in mind that credit ratings are not static—whether corporate or sovereign—and that in making an investment or structuring a portfolio, credit quality migration—downward—should be expected and factored into one’s investment outlook, strategy and return forecast.
PERSISTENT AND SUSTAINED DOWNWARD CREDIT MIGRATION: SOME EXPLANATIONS
What are possible explanations for this persistent and sustained downward migration? Potential reasons include:
All of these factors, as well as globalization and the massive growth of global debt capital markets, have in one way or another contributed to, or help explain, why credit quality has been steadily deteriorating for many years. It is my belief that this course will most likely continue for some time to come.
Performance data shown represents past performance and is no guarantee of, and not necessarily indicative of, future results.
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