For years, investors have fretted over the swelling mass of BBB rated bonds in the world of investment-grade credit.
These are corporate bonds that sit at the lowest rung of high grade, just one notch above ‘junk’ status. As such, they’ve been the source of much consternation for anyone worried about a deteriorating credit market, with the proportion of BBB rated bonds in benchmark indices having swelled to a record 51.9% in recent years.
But the tide is turning, according to a new note from Bank of America Corp.
A wave of post-pandemic upgrades means the share of BBB rated bonds in major indices has now dropped to 47.5%, with a stunning $100 billion worth of debt upgraded from the category into single-A this year alone. It’s not what many of the commenters who have been warning of a ‘Triple B Bubble’ may have expected. And it suggests that the so-called bubble may be deflating in a relatively orderly fashion as a slew of BBB companies improve their balance sheets without a dramatic spike in bankruptcies and big market stress.
“This upgrade cycle is the reflection of companies shoring up their balance sheets ahead of a potential recession, originally expected for this year,” write BofA analysts led by Yuri Seliger. “The record pace of upgrades has partially reversed the big downgrade cycle following the global financial crisis.”
So great is this upgrade trend, that the analysts think it may go someway towards explaining why credit spreads, or risk premiums on corporate bonds, have remained so low even after the Federal Reserve hiked interest rates at the fastest pace in decades.
They estimate that spreads on the investment-grade bond index would be two basis points higher without the mass of upgrades. That means rating actions have gone from a headwind in 2020 — when companies were being downgraded as a result of economic headwinds from the pandemic — to a tailwind in 2022.
It’s a point picked up by other credit experts, with Wayne Dahl, managing director and investment risk officer at Oaktree Capital Management, also noting the trend in a recent episode of the Odd Lots podcast. As he puts it, a rash of corporate failures in 2020 helped clear out some of the junkiest junk in the high-yield market, while many investment-grade companies have taken advantage of years of low interest rates to term out their debt and bulk up teir balance sheets.
“Because of that default rate, you cleared out a lot of the lowest rated companies that were under the most stress. Simultaneously, you had a number of downgrades, so triple B-rated securities into Double-B or Single B-rated into high yield,” he said. “You've had actually more upgrades than downgrades in that [high-yield] market, which may be surprising given, you know, all the talk of recession and the need for spreads to be wider.”
Of course, rating agencies have a reputation for being somewhat backward-looking (or outright wrong) and their categorization of any corporate bond can quickly change along with companies’ collective fortunes and the general economic outlook. But for now, it looks like triple-B dominance may be ending not with a bang of downgrades, but a burst of upgrades.