A decade of low borrowing costs and a strengthening economy have fueled unprecedented growth and depth in the U.S. credit markets. As of year-end 2018, our total forecast balance sheet debt for U.S. nonfinancial corporates in the 'BBB' category has grown to just under $3 trillion, up roughly 171% since 2007. Moreover, industry consolidation and acquisition activity have created sizeable debt concentrations among certain sectors and issuers, which could pose risks given the larger amount of debt relative to past cycles. Accordingly, investors' questions have frequently centered on how future downgrades could affect the credit markets, and particularly around forced selling and the ability of the speculative-grade market to absorb a large amount of long-dated "fallen angel" debt (i.e. debt downgraded to speculative grade from investment grade).

In this FAQ, we dive deeper into credit fundamentals within the 'BBB' category and look to size the potential downgrade risks. We based our analysis on authoritative S&P Global Ratings data and credit metrics used to determine 'BBB' ratings. This is particularly important in assessing the actual amount of 'BBB' debt outstanding, the actual debt leverage for the issuers, and future expectations for ratings performance, which is based on our forward-looking analytics. Our analysis used a bottom-up approach, focusing on issuers' credit quality and overlaying historical ratings performance against the current makeup of the 'BBB' category. This analysis indicated that 'BBB' debt at risk of falling to speculative grade in the next recession would be relatively comparable to past cycles taken as a percentage of the speculative-grade bond market. However, every cycle is unique, so we looked to further explore the strengths and potential vulnerabilities that could affect ratings performance in the next downturn.

Frequently Asked Questions

How have 'BBB' ratings performed in both benign and stressful economic periods?

For U.S. nonfinancial corporates, ratings have performed well during these periods as key indicators of credit risk for market participants. According to S&P Global Fixed Income Research, between 1981-2017, on average, approximately 4.8% of 'BBB' issuers transitioned to speculative grade over a one-year period. Even during the financial crisis, we did not see a marked increase in 'BBB' downgrades to speculative grade relative to this historical average. In fact, the one-year 'BBB' downgrade rate was approximately 5% and 4.5% in 2008 and 2009, respectively (see chart 1). These rates highlight that 'BBB' U.S. nonfinancial corporate ratings performed extremely well during the most severe downturn since the Great Depression, when issuers experienced material declines in both business and consumer spending.

Chart 1

Looking at the cumulative 9.5% transition rate in 2008-2009--which translates to 48 fallen angel issuers--just under 60% were rated 'BBB-' at the start of 2008, one-third were rated 'BBB', and the remainder were rated 'BBB+' or higher (see chart 2). This is notable because the bulk of the downgrades came from the lowest-rated cohort of 'BBB-', as expected given that these issuers exhibit the weakest credit quality within the 'BBB' category. This cohort also contains the lowest percentage (19%) of 'BBB' category debt today (see chart 3).

Chart 2

Chart 3

Based on past cycles, how much 'BBB' debt could be at risk of falling to speculative grade in the next downturn?

We believe a good way to estimate future downgrades is a bottom-up approach using historical issuer transition rates since issuers, not debt, are subject to becoming fallen angels. This approach also considers issuer growth because while 'BBB' debt has increased substantially, it's now spread across a larger issuer base that has increased roughly 40% since 2007.

Based on our scenario analysis, assuming the severity of the next downturn is in line with the Great Recession, potential 'BBB' fallen angel debt would be $200 billion-$250 billion (see table 1 and chart 4). We estimate this by taking the cumulative two-year transition rate of 9.5% and segmenting it by rating level (e.g. 60% from 'BBB-', 31% from 'BBB', and 9% from 'BBB+' based on chart 2). We then apply these rates against our 2018 forecast S&P Global Ratings-reported debt at each rating level within the 'BBB' category (see chart 3). The $200 billion-$250 billion estimate includes all nonfinancial sectors, including more highly leveraged sectors such as real estate (primarily REITs) and regulated utilities, which accounted for nearly 30% of 'BBB' fallen angels in the financial crisis. While $200 billion-250 billion is meaningful, as a percentage of the speculative-grade bond market this is relatively in line with fallen angel debt in past cycles. While no extrapolation is perfect and every cycle is unique, we believe these estimates put the amount of potential downgrades into a better perspective. In terms of market liquidity implications, we believe the risks will be around the timing of potential downgrades and whether any large debt holders become fallen angels.

Table 1

Chart 4

How much has debt leverage increased in the 'BBB' category since the financial crisis?

Median adjusted leverage in the 'BBB' category increased materially to 2.2x in 2018 from 1.8x in 2007 (see chart 5). While a large percentage increase, it's still commensurate with the strength of the businesses in the rating category. Leverage peaked in 2016, at a little over 2.3x on a median basis, and has since been on a downward trend that we expect to continue with tighter monetary conditions. More importantly for credit quality, growth in free operating cash flow (FOCF) to debt for 'BBB' issuers has exceeded growth in leverage--a trend that we also expect to continue in 2018 and 2019 with the benefits of tax reform (see chart 6).

Chart 5

Chart 6

Could higher leverage cause 'BBB' ratings to underperform relative to past cycles?

No, we do not believe so given that median 'BBB' leverage remains in line with rating parameters and pockets of higher leverage tend to be concentrated in more stable sectors. As of year-end 2018, we expect only 11% of 'BBB' issuers to be leveraged above 4x, declining to about 5% in 2019. These forward-looking forecasts include our baseline economic assumptions of slowing GDP growth through 2019, along with industry-specific assumptions around slowing demand and ongoing secular shifts due to factors such as technology disruption.

Chart 7a

Chart 7b

While we include all sectors in our $200 billion-$250 billion fallen angel extrapolation, when discussing leverage in the 'BBB' category we believe it's appropriate to differentiate by sector. Deeper analysis reveals that pockets of higher leverage tend to be concentrated among some of the most stable industries, which can generally tolerate higher debt loads due to the stability and visibility of cash flows and leveragability of hard assets. Our results showed that:

• Approximately 84% of 'BBB' debt leveraged above 5x falls within the real estate (REIT issuers), regulated transmission/transport, and regulated utilities sectors (see charts 8 and 9), which account for 40% of total 'BBB' category debt.
• Because of their favorable volatility characteristics, we apply different thresholds to these sectors within our methodology, so it can be misleading to include them when using leverage as the sole indicator of credit quality.
• Outside of these sectors, 90% of 'BBB' debt is projected to have leverage below 4x by 2019, and moreover, 70%-80% of 'BBB' debt is leveraged below 3x in both our 2018 and 2019 forecast years (see chart 7).

Chart 8

Chart 9

Are there pockets of higher leverage outside of the real estate and regulated sectors?

Yes, pockets of higher leverage outside of REITs and regulated sectors tend to be the result of recent merger and acquisition (M&A) activity. Here it's important to note that our ratings are forward-looking as opposed to point-in-time, which means that credit metrics such as leverage could temporarily deviate from what we would consider appropriate for a rating level. When rating M&A transactions investment grade, we typically look out over a two-year horizon, incorporating both our industry- and company-specific outlook and our economists' baseline expectations into our forecast. While we do not apply a different methodology for M&A, depending on where we might be in the credit cycle we may incorporate risks (e.g. potential for future cash flow volatility) that aren't fully reflected in our economic outlook.

One sector that stands out as having a larger percentage of 'BBB' debt leveraged above 4x due to M&A is consumer products. While this could pose risks depending on the timing of a potential turn in the credit and/or economic cycle, we believe there are various mitigating factors:

• The amount of consumer debt is small relative to the size of the overall 'BBB' category (see charts 8 and 9). We project roughly 17% of 'BBB' consumer debt will be leveraged above 4x by 2019--only 2% of total U.S. nonfinancial corporate 'BBB' debt.
• Consumer products performed well during the last downturn (see chart 10), and the deleveraging path for consumer packaged goods companies has typically been supported by strong discretionary cash flow generation, even after large dividend payouts (which can be reduced or eliminated in a downturn).
• Since the recession investment-grade consumer goods issuers have improved their cost structures and made progress in repositioning their portfolios, which should benefit performance in the next downturn. (See "When The Cycle Turns: Will Consumer Companies' M&A-Related Debt Result In An Exodus From Investment Grade?" published July 25, 2018.)

Chart 10

Where are potential vulnerabilities in the 'BBB' rating category?

As we saw during the financial crisis, the majority of fallen angels came from the 'BBB-' rated cohort, while multinotch downgrades were in the minority. In today's market, 'BBB-' rated issuers account for about $572 billion in S&P Global Ratings-reported debt, or about 19% of the overall 'BBB' market (see chart 3). Within this cohort, we consider issuers rated 'BBB-' with negative outlooks or ratings on CreditWatch with negative implications as the most vulnerable to being downgraded to speculative grade. As of Oct. 31, 2018, 16 public issuers fell into this bucket, with about $71 billion of associated debt (see table 2).

Table 2

However, we recognize that issuers that currently have stable outlooks or are rated higher than 'BBB-' are also subject to credit deterioration during a recession. To further analyze these vulnerabilities, we examined median headroom against S&P Global Ratings' downgrade triggers (defined as the percent EBITDA decline that would cause a breach of an S&P Global Ratings one-notch downgrade threshold). We found that:

• While certain issuers have temporarily pushed leverage up against or above our downgrade thresholds due to M&A, these are not the norm.
• The median cushion of EBITDA headroom against our downgrade triggers in the 'BBB' category is relatively strong, at above 34% for most sectors (see chart 11).
• For 'BBB-' issuers that would be most susceptible to becoming fallen angels, median headroom is about 27% against a one-notch downgrade, which increases to 31%-36% if issuers reduce or eliminate shareholder returns (see table 3).
• For 'BBB' and 'BBB+' rated issuers, on a median basis there is strong cushion against a one-notch downgrade, which we believe further supports the conclusion that multinotch downgrades won't be common in the next recession, similar to past cycles. This is notable because over 80% of 'BBB' category debt sits within these rating cohorts.

Chart 11

Table 3

Debt concentration is uneven among 'BBB' issuers. Could this lead to a higher amount of fallen angel debt if larger debt holders are downgraded?

One potential flaw of estimating potential fallen angels is that debt concentration us uneven among 'BBB' rated issuers. For example, the downgrade of the two largest debt holders (see table 4) would lead to more than $300 billion of debt falling into the speculative-grade market. While this is true, analysis of the 'BBB' category reveals that debt is concentrated among some of the most stable companies and sectors.

A further examination of the top 20 debt holders, which account for over 30% of 'BBB' category debt, indicates that nearly 95% of these issuers have business profile assessments typically held by 'A' category or higher-rated entities (see table 4). This is not surprising given that growth in 'BBB' debt has been driven in part by migration from higher rating categories. In fact, approximately 10% of current 'BBB' credits were rated in the 'A' category or higher a decade ago--about one-third of the total 'BBB' debt outstanding today. Many of these transitions were the result of management financial policy decisions as companies pursued capital structures to support their operational strategies and bolster shareholder returns (see "When The Cycle Turns: U.S. 'BBB' Corporate Profiles Remain Firm Despite Rising Debt," published July 25, 2018). While this does not mean these companies aren't at risk of credit deterioration, many have diversified their businesses through acquisitions, have industry-leading profitability, good cash flow generation, and generally have more scope to alter their financial policies in the face of a downturn.

Table 4

At a sector level, there is also a high concentration of 'BBB' debt among more stable sectors such as regulated utilities, telecommunications, and REITs/real estate (see chart 12). These three sectors alone account for roughly 48% of 'BBB' category debt, with other notable concentrations in consumer products (6%), oil and gas (7%), and retail and restaurants (8%). All of these factors highlight that debt concentrations are less likely to lead to large amounts of fallen angels in the next downturn.

Chart 12

Related Research

• When The Cycle Turns: U.S. 'BBB' Corporate Profiles Remain Firm Despite Rising Debt, July 25, 2018
• When The Cycle Turns: As U.S. 'BBB' Debt Growth Sparks Investor Concern, Near-Term Risks Remain Low, July 25, 2018
• When The Cycle Turns: Will Consumer Companies' M&A-Related Debt Result In An Exodus From Investment Grade?, July 25, 2018