Record number of company credit ratings are on the cusp of ‘fallen angel’ downgrades
As benchmark interest rates in the U.S. rise and the pace of corporate earnings growth slows, Moody’s Investors Service warned Friday that an unprecedented number of corporate credit ratings could be added to the “junk” pile.
Moody’s said the dollar value of U.S. corporate bonds outstanding rated at its lowest investment-grade rung of Baa rose to a record $2.83 trillion in the third quarter, topping the $2.62 trillion in single-A corporate bonds and the $629 billion in outstanding bonds rated Aa or higher.
Within the Baa rung, the dollar amount of bonds rated Baa 3—Moody’s lowest investment-grade rating—ballooned by 140% from the fourth quarter of 2007 to a record $705 billion in 2018’s third quarter. Read more about Moody’s ratings.
‘At a minimum, the FOMC should take every precaution with its ongoing firming of monetary policy so as to not risk a slowdown by domestic expenditures that is capable of shrinking profits by enough to significantly boost corporate debt repayment problems.’
Perhaps more significantly, Baa 3-grade corporate debt outstanding reached an “unprecedented” 56.8% of speculative-grade, or “junk,” high-yield corporate bonds outstanding. By comparison, the ratio of outstanding Baa 3-rated bonds to high-yield bonds was 32.5% before the 2008-2009 financial crisis, 36.9% before the 2001 recession and 22.2% before the 1990-1991 downturn.
“All else the same, investment-grade bonds rated Baa 3 are at the greatest risk of incurring a fallen-angel downgrade,” John Lonski, chief economist at Moody’s Capital Markets Research wrote in a note to clients. “Fallen angel” refers to a bond that is downgraded to junk from investment-grade.
“Thus, from the perspective of dollar amounts outstanding, the U.S. investment-grade corporate-bond market is now riskier than it was before each recession since 1981 and possibly all prior downturns through the late 1940s,” Lonski said.
To reflect that risk, the yield on composite long-term Baa industrial company bonds rose to 202 basis points (2.02 percentage points) above comparable yields on Treasury notes on Nov 14. See Bond Report.
“Greater uncertainty surround the sustainability of corporate earnings growth has adversely affected the performance of medium- and lower-grade bonds,” Lonski wrote. “Not since September 2016 has the long-term Baa industrial spread remained above 200 basis points on a recurring basis.”
High-yield bonds were hit even harder recently, amid concerns over a potential surge in supply as shrinking corporate earnings lead to a jump in fallen-angel downgrades. The spread over Treasurys of a composite speculative-grade bond yield jumped to 415 basis points on Nov. 14 from 371 basis points a week earlier.
Continued interest-rates increases by the Federal Reserve’s Federal Open Market Committee (FOMC), the Fed’s rate-setting arm, could increase credit risks by slowing corporate investment and reducing earnings growth.
“The combination of a sudden expansion of outstanding high-yield bonds and a fast rising default rate could swell Baa and high-yield corporate credit spreads. In all likelihood, systemic liquidity would be greatly diminished and a credit crunch would ensue,” Lonski said. “At a minimum, the FOMC should take every precaution with its ongoing firming of monetary policy so as to not risk a slowdown by domestic expenditures that is capable of shrinking profits by enough to significantly boost corporate debt repayment problems.”
Based on consensus analyst earnings estimates of companies in the S&P 500 index SPX, +0.42% compiled by FactSet, year-over-year earnings-per-share growth may have just peaked. With about 93% of the S&P 500 companies reporting third-quarter results, EPS rose 25.8% from a year ago, following 25.2% growth in the second quarter and 25.0% growth in the first quarter.
For the fourth quarter, the FactSet consensus forecast is for growth to slow to 13.8%.
Meanwhile, the FOMC is widely expected to raise its target for overnight interest rates by 25 basis when it concludes its two-day policy meeting Dec. 19.
“In summary, the now record high ratio of Baa 3 bonds outstanding to high-yield bonds outstanding warns of a potentially very disruptive surge in fallen-angel downgrades once the next deep and prolonged contraction by profits arrives,” Moody’s said.