Upwardly mobile: credit’s quest for glory
Fixed income portfolio managers Tom Ross and Tim Winstone explore how a drive to improve among corporate borrowers can have winning results for both companies and investors.
5 minute read
Key takeaways:
- The past two years has seen the credit rating upgrade/downgrade ratio swing from a decade low to a decade high.
- Absent a shock we anticipate a particularly strong year in 2022 for corporate bond issuers moving from high yield to investment grade status.
- The large spread differentials between BB and BBB rated bonds and pricing inefficiencies in the crossover space continue to make this an important area of fixed income for return potential.
There has been no shortage of sporting events in 2021. The passion to compete, to climb the rankings and secure glory are a powerful motivator. The corporate world is equally competitive, with companies seeking to drive returns for their investors and wider stakeholders.
Misnomer
2021 was a peculiar year for sport, with the Euro 2020 football championship and Olympics 2020 carrying the moniker of the previous year. In our view, something similar has occurred in the world of corporate credit where bond issuers are still carrying the credit rating of yesteryear.
The fear back in 2020 as coronavirus took hold was that companies would be debilitated by the closure of swathes of the economy. Many companies turned to capital markets to tide them through the difficult days of revenue shortfalls. This consisted either of equity capital raised from shareholders, loans from banks or debt from issues of bonds. Leverage levels in aggregate climbed for both investment grade and high yield bond issuers. Credit rating agencies tried to look through the COVID-19 difficulties but with so much uncertainty companies’ creditworthiness had to be marked against what was visible.
As a result, 2020 was a year in which credit rating downgrades exceeded upgrades by a wide margin. Taking just the US as an example, the upgrade/downgrade ratio plunged to a low for the past decade.
Source: Bloomberg, S&P Ratings, Corporate Ratings, All (investment grade and high yield), US, Q1 2011 to Q4 2021 (Q4 2021 up to 18 November 2021).
2021 has seen a sharp recovery, with the ratio firmly above 1, signifying an excess of upgrades over downgrades. Helping to drive the advance has been a recovery in cash flow and earnings among companies. Balance sheets have improved as companies have used the low yield environment to refinance at attractive rates.
This positive momentum within credit upgrades has powerful repercussions for the outlook for rising stars. These are issuers who make the move from high yield to investment grade status. Typically, this involves incremental gains as credit rating agencies gradually raise the credit rating of a bond a notch or two, say from BB- to BB+ and then to BBB- (using the S&P methodology as an example).
There was such a volume of downgrades in 2020 that this created a pool of companies that sit just below investment grade and are potentially ripe for elevation to investment grade status. JPMorgan reckons there could be as much as US$277 billion of bonds globally that could make this migration by mid-2023 (absent another economic shock).
Source: J.P.Morgan, ex emerging market issuers, at 30 September 2021. Data beyond 2020 are estimates, and there is no guarantee that past trends will continue or that forecasts will be realised.
Why is this important? Well, there remains a significant cost difference between a high yield rating and an investment grade rating for bond issuers. For example, the average credit spread on a high yield BB rated bond is 218 basis points (bps) compared with 115 bps for an investment grade BBB rated US bond, a spread differential (218 minus 115) of 103 bps. The spread differential is even more stark in Europe where BB rated bonds trade on average with spreads of 256 bps compared with 114 bps for the BBB cohort.1 In fact, the spread ratio (BB spread divided by BBB spread) is relatively high historically, which could be taken to indicate better value in BB rated bonds compared with BBB rated bonds.
These spread differentials of 100 basis points or more offer potential opportunities to benefit from spread narrowing as some bonds climb the credit rating ranking. This can offer a win-win situation for both investors (as existing bonds reprice higher from any decline in yield) and the issuing company (as the cost of borrowing declines).
The reasons for upgrades are varied. For example, Fiat Chrysler was upgraded in January 2021 as Fiat Chrysler merged with stronger-rated Peugeot to create Stellantis, as well as on expectations the auto industry would rebound from the COVID-19 downturn. JBS, the Brazilian meatpacker, was upgraded in November 2021 because of strong demand for protein from a recovering US economy and its positive free cash flow generation.
Creative disruption
For some companies the disruption caused by COVID-19 and the associated lockdowns was not all bad news. This is because it caused a realignment of consumer habits. One of the major beneficiaries was Netflix, the content streaming company, which saw a massive jump in subscriber numbers as households – deprived of external entertainment – flocked to its streaming service. As a result, S&P moved to upgrade Netflix to investment grade in October 2021, citing Netflix’s improving margins and positive cash flow expectations.
Identifying potential candidates for upgrade can therefore prove profitable for investors and it is one of the reasons why the crossover space between investment grade and high yield remains, in our view, one of the most compelling areas for seeking returns within fixed income.
1Source: Bloomberg, ICE BofA BBB US Corporate Index, ICE BofA BB US High Yield Index, ICE BofA BBB Euro Corporate Index, ICE BofA BB Euro High Yield Index, Govt OAS, 18 November 2021. Basis point equals 1/100th of a percentage point. 1bps = 0.01%, 100 bps = 1%.
Credit spread: The additional yield (typically expressed in basis points) of a corporate bond (or index of bonds) over an equivalent government bond.
Crossover space: The credit ratings area surrounding the border between investment grade and high yield.
High yield: A bond that has a lower credit rating than an investment grade bond. Sometimes known as a sub-investment grade bond. These bonds carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher coupon to compensate for the additional risk
Investment grade: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments. The higher quality of these bonds is reflected in their higher credit ratings.
Leverage: The level of debt at a company.
Upgrade/downgrade: A bond is upgraded when it is given a higher credit rating eg moves from BB to BB+. A downgrade is when a bond is given a lower credit rating.
Ratings/credit ratings: A score assigned to a borrower, based on their creditworthiness. It may apply to a government or company, or to one of their individual debts or financial obligations. An entity issuing investment grade bonds would typically have a higher credit rating than one issuing high yield bonds. The rating is usually given by credit rating agencies, such as Standard & Poor’s or Fitch, which use standardised scores such as ‘AAA’ (a high credit rating) or ‘B-‘ (a low credit rating). Moody’s, another well known credit rating agency, uses a slightly different format with Aaa (a high credit rating) and B3 (a low credit rating) as per the table below. The ratings spectrum starts at the top with AAA (highest quality) and progresses down the alphabet to C and D, which indicate a borrower that is vulnerable to defaulting or has defaulted.
These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.
Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
The information in this article does not qualify as an investment recommendation.
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Important information
Please read the following important information regarding funds related to this article.
- An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
- When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise (or are expected to rise). This risk is typically greater the longer the maturity of a bond investment.
- The Fund invests in high yield (non-investment grade) bonds and while these generally offer higher rates of interest than investment grade bonds, they are more speculative and more sensitive to adverse changes in market conditions.
- Some bonds (callable bonds) allow their issuers the right to repay capital early or to extend the maturity. Issuers may exercise these rights when favourable to them and as a result the value of the Fund may be impacted.
- If a Fund has a high exposure to a particular country or geographical region it carries a higher level of risk than a Fund which is more broadly diversified.
- The Fund may use derivatives to help achieve its investment objective. This can result in leverage (higher levels of debt), which can magnify an investment outcome. Gains or losses to the Fund may therefore be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- If the Fund holds assets in currencies other than the base currency of the Fund, or you invest in a share/unit class of a different currency to the Fund (unless hedged, i.e. mitigated by taking an offsetting position in a related security), the value of your investment may be impacted by changes in exchange rates.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- CoCos can fall sharply in value if the financial strength of an issuer weakens and a predetermined trigger event causes the bonds to be converted into shares/units of the issuer or to be partly or wholly written off.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
Specific risks
- An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall. High yielding (non-investment grade) bonds are more speculative and more sensitive to adverse changes in market conditions.
- When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise (or are expected to rise). This risk is typically greater the longer the maturity of a bond investment.
- Some bonds (callable bonds) allow their issuers the right to repay capital early or to extend the maturity. Issuers may exercise these rights when favourable to them and as a result the value of the Fund may be impacted.
- Emerging markets expose the Fund to higher volatility and greater risk of loss than developed markets; they are susceptible to adverse political and economic events, and may be less well regulated with less robust custody and settlement procedures.
- The Fund may use derivatives to help achieve its investment objective. This can result in leverage (higher levels of debt), which can magnify an investment outcome. Gains or losses to the Fund may therefore be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- The Fund may incur a higher level of transaction costs as a result of investing in less actively traded or less developed markets compared to a fund that invests in more active/developed markets.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- CoCos can fall sharply in value if the financial strength of an issuer weakens and a predetermined trigger event causes the bonds to be converted into shares/units of the issuer or to be partly or wholly written off.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
- In addition to income, this share class may distribute realised and unrealised capital gains and original capital invested. Fees, charges and expenses are also deducted from capital. Both factors may result in capital erosion and reduced potential for capital growth. Investors should also note that distributions of this nature may be treated (and taxable) as income depending on local tax legislation.
Specific risks
- An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
- When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise (or are expected to rise). This risk is typically greater the longer the maturity of a bond investment.
- The Fund invests in high yield (non-investment grade) bonds and while these generally offer higher rates of interest than investment grade bonds, they are more speculative and more sensitive to adverse changes in market conditions.
- Some bonds (callable bonds) allow their issuers the right to repay capital early or to extend the maturity. Issuers may exercise these rights when favourable to them and as a result the value of the Fund may be impacted.
- If a Fund has a high exposure to a particular country or geographical region it carries a higher level of risk than a Fund which is more broadly diversified.
- The Fund may use derivatives to help achieve its investment objective. This can result in leverage (higher levels of debt), which can magnify an investment outcome. Gains or losses to the Fund may therefore be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- If the Fund holds assets in currencies other than the base currency of the Fund, or you invest in a share/unit class of a different currency to the Fund (unless hedged, i.e. mitigated by taking an offsetting position in a related security), the value of your investment may be impacted by changes in exchange rates.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- CoCos can fall sharply in value if the financial strength of an issuer weakens and a predetermined trigger event causes the bonds to be converted into shares/units of the issuer or to be partly or wholly written off.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
Specific risks
5 minute read
Key takeaways:
- The past two years has seen the credit rating upgrade/downgrade ratio swing from a decade low to a decade high.
- Absent a shock we anticipate a particularly strong year in 2022 for corporate bond issuers moving from high yield to investment grade status.
- The large spread differentials between BB and BBB rated bonds and pricing inefficiencies in the crossover space continue to make this an important area of fixed income for return potential.