The composition of the US corporate investment grade (IG) market has undergone a dramatic transformation over the last decade. A boom in debt-fuelled M&A and share repurchase activity has contributed to an increase in leverage and an explosion in BBB-rated US IG corporate debt. There are signs that while downgrades have happened, credit rating agencies have been arguably too lenient in some cases, placing too much faith in the ability/desire of companies to de-lever within a target timeframe.
However, the general trend of increased leverage is consistent with a strengthening economic backdrop. The US economy remains in the midst of a protracted economic expansion that began almost a decade ago and, should it continue into summer 2019, will become the longest expansion in its history. Along with the recent tax reforms, this presents a very favourable environment for corporate America. The tax reforms should lead to an improvement in corporates’ free cash flow, which would enable them to manage higher leverage burdens; and the now higher after-tax cost of debt makes it less attractive from an issuer’s perspective. This should pour some cold water on opportunistic debt issuance. Along with still-easy monetary policy, an economy at full employment and the Federal Reserve’s preferred measure of inflation hitting 2% for the first time in six years, and the increase in corporate leverage makes more sense.
We would also note that valuations of BBB-rated debt still appear attractive in the context of historical loss rates. That said, if the credit cycle turns and companies do not sufficiently delever, rating agencies may be forced to downgrade some of these large-cap companies to high yield. We therefore believe security selection has become ever-more important.
Peter Bentley – head of UK and global credit. Insight Investment, a BNY Mellon company