Bullish Credit Cycle Prolonged by $70 Billion Rating Upgrades
End-of-Cycle Is Delayed in Stubbornly Healthy Credit Markets
(Bloomberg) -- For all the talk that the business cycle is teetering on the edge of a downturn, debt markets tell a different story.
Upgrades of corporate credit will prevail over downgrades this year, according to strategists at Bank of America Corp., who expect a flood of “rising star” promotions to investment-grade. Risk premiums for junk bonds are moving ever closer to those of higher-rated peers. And funds that profit from fallen-angel downgrades are underperforming, while those that specialize in distressed debt are scrapping over one of the smallest groups of tradable bonds in four years.
Sure, investors are receiving paltry compensation for economic and interest-rate risks. But corporate bonds aren’t signaling the doomsday scenarios laid out this month by some participants at the Milken Institute Global Conference in Beverly Hills, dubbed the “Davos of the West.”
For now, the expanding business cycle is trumping the more restrictive monetary environment, as evidenced by the bull market in junk bonds and low default rates. Higher oil prices and rising borrowing costs have spurred a hunt for shorter-duration bonds with cash flows linked to growth -- paving the way for the outperformance of high yield over high-grade bonds with longer maturities.
“If rates continue to rise as we expect and oil prices rally, we would not be surprised to see high yield continue to outperform,” JPMorgan Chase & Co. strategists Alex Roever and Kimberly Harano wrote in a note.
The synchronized global growth story is intact, too. Credit upgrades outpaced downgrades by $20 billion in the first four months of the year, and there are some $70 billion of net upgrades to high grade on the cards for 2018 as a whole, according to Bank of America strategists.
The lender projects a total of $24 billion of fallen angels -- downgrades to high yield -- across developed and emerging markets this year, near the bottom of the historical range.
Fallen angels have been made rare by a decade of near-zero rates that have let companies stave off downgrades by shrinking their debt bills. The market value of a Bank of America index tracking fallen-angels has dwindled to the least since October 2014 as upgrades have lifted rising stars out of the group.
“Faster economic growth and an increase in after-tax cost of debt (following the U.S. tax reform) will lead to improving credit fundamentals this year,” strategists led by Hans Mikkelsen wrote in a report this month.
The global high-yield default rate will drop to 1.7 percent by the end of this year compared with 2.9 percent in late 2017 and a long-term average of 4.2 percent, according to Moody’s Investors Service Inc.
Doomsday Delayed
A turnaround expert at FTI Consulting Inc. says the long-predicted spike in defaults will fully materialize in 2020, trailing nine months to a year behind the point when credit markets tighten.
Companies will need to refinance an estimated $4 trillion of bonds over the next five years, about two-thirds of all their outstanding debt, according to Wells Fargo Securities. Much of that is in the BBB category, verging on junk.
Yet super-low rates have helped these borrowers reduce their average bond coupons to 4.3 percent, compared with 8.9 percent at the end of 2000. That has set them up well for a future in which they may face higher rates, according to Marty Fridson, the chief investment officer at Lehmann Livian Fridson Advisors.
A BBB-rated borrower might have to refinance some of its maturing obligations at 6 percent, but by the time it has to repay the rest, “the company will have had ample opportunity to ratchet down its debt to adjust its leverage to the higher rates, just as it ratcheted its leverage up in the earlier period,” Fridson wrote in a note on Sunday.
Fran Rodilosso at Van Eck Associates Corp. isn’t holding his breath for a big wave of corporate downgrades either, even as the firm launches a new global fallen angel fund.
“You don’t see anything like that about to happen right now,” said Rodilosso. He predicts market-wide pain will be pushed back until “three or four years” from now as synchronized global growth and low rates boost corporate refinancing.
--With assistance from Yakob Peterseil
To contact the reporters on this story: Sid Verma in London at sverma100@bloomberg.net, Cecile Gutscher in London at cgutscher@bloomberg.net.
To contact the editors responsible for this story: Samuel Potter at spotter33@bloomberg.net, Yakob Peterseil
©2018 Bloomberg L.P.
