Diagram 1

The growth of the nonfinancial corporate debt market rated in the 'BBB' category by S&P Global Ratings has been stellar since the end of 2015, both in the U.S. and Europe, the Middle East, and Africa (EMEA). In the U.S., the amount of rated long-term bonds within this category rose nearly 39% between the end of 2015 and mid-2019 (to $2.5 trillion from $1.8 trillion), while the total in EMEA increased roughly 49% (to $1.4 trillion from $0.9 trillion) (see chart 1).

Chart 1

'BBB' Segment Experiences Yearslong Boom Amid Low Interest Rates

This pace of growth in the 'BBB' market in recent years is largely attributable to very low interest rates since the financial crisis in both the U.S. and Europe. Years of monetary stimulus in the form of lower policy rates and various forms of quantitative easing have pushed corporate borrowing costs down while investors have pursued a yearslong hunt for yield. This has allowed 'BBB' companies to issue at rates once enjoyed by 'A' and even 'AA' issuers (see charts 2 and 3). In fact, many higher-rated firms have been making decisions (such as debt-funded mergers and acquisitions and shareholder returns) that have led to downgrades to 'BBB', in part due to the minimal difference in the relative cost of funding (see "To 'BBB', Or Not To 'BBB': Management Decisions Spur Most U.S. Corporate Downgrades To 'BBB'," Sept. 5, 2019).

Chart 2

Chart 3

But This Growth Is Feeding Worries Among Many Stakeholders

This large buildup in debt one rating category above speculative grade ('BB+' or lower) is raising concerns among stakeholders over the risk of companies becoming fallen angels (issuers downgraded to speculative grade from investment grade) and the ability of the speculative-grade market to absorb potentially large amounts of downgraded debt. However, the speculative-grade market has shown its ability to absorb large amounts of downgraded 'BBB' debt in the past (see "The U.S. Speculative-Grade Market Can Withstand 'BBB' Downgrades," April 24, 2019).

That said, the relative vulnerability of the speculative-grade bond market is currently quite high: At the end of October 2019, the amount of outstanding debt within S&P Global Ratings' U.S. 'BBB' bond composite was $2 trillion, over 2.5 times the amount in our speculative-grade composite (see chart 4). For more information regarding our U.S. corporate bond spread composites, please see Appendix II.

Chart 4

This marks the highest ratio on record since 2003. And this shift has been relatively recent: At the end of 2018, the 'BBB' composite was roughly 1.8 times as large as the speculative-grade one. The expansion during 2019 has not occurred due to growth in the 'BBB' composite, but rather due to a large decline since the start of 2019 in the speculative-grade composite. Both bond composites have seen declines this year in outstanding debt amounts, which has coincided with a drop in the number of bonds in each as well.

While we believe that downgrade risk is still generally low, the outstanding dollar amount of 'BBB-' bonds eligible for inclusion in our U.S. composites has been growing fairly quickly, relative to the outstanding amount of speculative-grade bonds eligible for inclusion, since the end of 2014 (see chart 5). In fact, it is now at an all-time high.

Chart 5

Current 'BBB' Market Indicators Reflect Calm, But Stress Is Set To Increase

After the financial crisis of 2008-2009, 'BBB' bond debt in the U.S. experienced a prolonged period of falling or stable spreads (see chart 6) and high returns (see chart 7). However, spreads in all rating categories of corporate bonds have been steadily rising since the start of 2018, and currently, they are all higher than they were a year ago.

Chart 6

Chart 7

The last few years have been an opportune time for 'BBB' rated issuers, given easing borrowing costs and a receptive investor market for new debt (see charts 8 and 9). Low borrowing costs have made it possible for many 'BBB' firms to accumulate growing amounts of outstanding debt while maintaining high relative credit quality.

Chart 8

Chart 9

In general, though with a few exceptions, the ratings stability of the 'BBB' segment in the U.S. and EMEA was high in the 12 months ended Sept. 30. In fact, on a trailing-four-quarter basis, the downgrade rate for EMEA nonfinancials is at an all-time low of only 1.1% through September (see charts 10 and 11). And of the ratings that have changed, a majority in both regions have been raised (see tables 5 and 6 in Appendix I).

Chart 10

Chart 11

Credit quality may have peaked, however, as downgrade potential has increased in both the U.S. and EMEA, particularly for the 'BBB-' segment (see tables 1 and 2). We measure downgrade potential using negative bias, or the proportion of issuers with negative outlooks or ratings on CreditWatch with negative implications. This shift in outlook and CreditWatch distributions is especially stark in EMEA, which showed a net positive bias (positive bias minus negative bias) for 'BBB-' issuers in September 2018 of 2.6% among nonfinancials, which swung 18 percentage points to -15.7% as of Sept. 30, 2019.

This large shift was the result of both a reduction in the number of companies with positive outlooks or CreditWatch statuses, as well as an increase in those with negative ones. At the 'BBB+' and 'BBB-' rating levels in EMEA, the net bias is leaning further into negative territory relative to a year ago, and for 'BBB-' nonfinancials, the net negative bias is higher than the long-term average, largely a result of the current negative bias, which finished the third quarter at 19%. In the U.S., negative net bias has increased at the 'BBB' and 'BBB-' levels, with the nonfinancial 'BBB-' negative bias--18% at the end of the third quarter--more than double the historical long-term average.

Table 1

Table 2

Examining The Biggest Issuers: Large And In Charge (Of Their Debt)

While high, the current outstanding rated debt of 'BBB' rated nonfinancial companies in the U.S. and EMEA is concentrated among the largest issuers. In terms of their share of the total amount of rated nonfinancial corporate bond debt, the top 10 issuers account for 32% in the U.S. and 28% in EMEA (see charts 12a and 12b).

Most of these companies are rated either 'BBB+' or 'BBB' and display somewhat lower risk of downgrades compared to the broader 'BBB' segments in these regions. In the U.S., markets appear to generally agree; as of Oct. 31, the median spread of these largest issuers is 31 basis points below the 'BBB' composite. This is not to say that there is no downgrade risk, but rather that the chances of a wave of significant downgrades among the largest issuers is currently limited, based on our examination of these largest 20 issuers.

Chart 12

In the U.S., 25% of 'BBB' category bonds are rated 'BBB-', the lowest rating within investment grade, while the 'BBB-' share for the top 10 is somewhat lower, at 18%. In EMEA, the shares rated 'BBB-' are a bit smaller, at 17% of the total 'BBB' category and 14% for the top 10. A larger share of the bonds from the top 10 issuers in EMEA are rated 'BBB+' (which is three notches above speculative grade), at 58% (see charts 13a and 13b), compared to 40% in the U.S.

Chart 13

Top 10 U.S. 'BBB' Borrowers Are Strong, Despite Some Drag From Autos

The 10 largest nonfinancial corporations we rate in the 'BBB' category in the U.S. have a high amount of debt--almost $900 billion of gross reported debt. We view transitions out of investment grade as unlikely for this cohort of companies. Nonetheless, we could see downgrades, particularly for more cyclical sectors such as auto manufacturers. This is notable because Ford Motor Co. and General Motors Co. represent 29% of the top 10's debt in the region. See table 3 in Appendix I for a full list of the top 10 U.S. 'BBB' companies.

Diagram 2

Debt levels and leverage for the top 10 borrowers have decreased slightly this year as a result of debt repayments at AT&T and General Electric, which offset United Technologies' and Broadcom's borrowing to fund acquisitions. Weighted average leverage has declined slightly, to 3x in mid-2019 from 3.2x at the end of 2018.

We expect credit metrics will continue to improve in 2020, with the majority of the top 10 maintaining relatively stable metrics and a few achieving more notable improvements. We expect leverage to decline at General Electric, CVS Health, and United Technologies in 2020, largely as a result of asset sales, continued debt repayment, and an all-stock merger, respectively.

Meanwhile, downgrade risk and upgrade potential for the top 10 are relatively balanced. In fact, two of these companies, Verizon and United Technologies, are rated 'BBB+', the highest 'BBB' category rating. The rating outlook on Verizon is positive, while the rating on United Technologies is on CreditWatch with positive implications, indicating that these companies could be upgraded to the 'A' category in 2020.

Verizon's focus on debt reduction should enable it to achieve adjusted leverage of 2.5x by 2020. The company's leverage was 2.7x as of June 2019, and we believe it has good prospects to reduce leverage to below 2.5x, which is our threshold for an upgrade to 'A-', by 2020. Raytheon's proposed merger with United Technologies' aerospace businesses (Pratt & Whitney and Collins Aerospace) is expected to improve the credit measures, scale, and diversity of the combined company. We could raise our rating on the company up to two notches, to 'A', once the transaction closes and we have competed our review of the transaction.

Three companies are rated 'BBB-': Ford Motor Co., Energy Transfer L.P., and Broadcom Inc. These represent 27% of the top 10 debt. The outlooks are stable.

Broadly Stable Leverage Expected For Top 10 'BBB' Companies In EMEA

The 10 largest nonfinancial corporates we rate in the 'BBB' category in EMEA also have a high amount of debt--almost $800 billion (about €720 billion) of gross reported debt outstanding (as of June 30, 2019). We regard this as a high degree of concentration, at about one-third of the $2.3 trillion borrowed by all 'BBB' category corporates in the region. (Note that this figure differs from the $1.4 trillion of rated 'BBB' debt but includes all debt borrowed by these issuers). See table 4 in Appendix I for a full list of the top 10 'BBB' EMEA companies.

Diagram 3

This concentration raises the question: How well placed are these largest issuers to withstand a credit cycle downturn leading to potential deterioration in credit metrics during 2019, 2020, and beyond? This was one of the questions we highlighted in "When The Cycle Turns: 'BBB' Downgrade Risks In EMEA Nonfinancial Corporates Appear Manageable," published April 15, 2019.

We do not expect a high number of large 'BBB' category issuers in EMEA to be downgraded to speculative grade during the next downturn. Six out of the top 10 issuers experienced a slight reduction in leverage year on year in 2018, with the average level stable at 2.8x S&P Global Ratings adjusted debt-to-EBITDA. Based on our published forecasts for each company for 2019 and 2020, we expect leverage to generally remain in similar ranges.

However, several companies had leverage above 3x at the end of 2018. We expect this to decline in 2019 and 2020 for some companies, such as:

• Enel SpA: based on increasing EBITDA, despite still neutral-to-slightly negative free operating cash flow;
• Telefonica S.A.: helped by EBITDA growth, asset disposals, tax refunds, and positive discretionary cash flow; and
• British American Tobacco PLC: supported by strong cash flow generation and focus on organic growth, with no expected material acquisitions in the medium term.

For others, leverage might slightly increase compared to end-2018, largely due to acquisitions, such as for:

• Vodafone Group PLC: which we recently downgraded to 'BBB' with a stable outlook from 'BBB+' following the closing of the acquisition of Liberty Global assets; and
• Deutsche Telekom AG: due to its planned acquisition of Sprint Corp., which is ongoing. Our 'BBB+' rating is on CreditWatch with negative implications, so it could be lowered when the acquisition closes.

Nevertheless, two companies are rated 'BBB-' with negative outlooks, so they face some downside risk to speculative grade. Together they have about $120 billion (about €105 billion) of reported debt outstanding (as of June 30, 2019). These two companies are part of three of the top 10 that have been downgraded in 2019. In addition to Vodafone, these are:

• Renault S.A.: which faces tougher auto market conditions, increasing competition, and the risk of regulatory fines; and
• Atlantia SpA: which faces ongoing uncertainties related to the Italian toll road concession operated by Atlantia's subsidiary Autostrade per l'Italia.

Appendix I: Additional Tables

Table 3

Table 4

Table 5

Table 6

Appendix II: Bond Composites Methodology

S&P Global Ratings Research provides U.S. option-adjusted spread composites consisting of more than 13,000 investment-grade and speculative-grade issues. Credit spreads are a measure of the market's valuation of credit risk and are quoted in basis points. They reflect daily movements in credit spreads within various bond market sectors.

The spreads are calculated daily above the U.S. Treasury yield curve for various bond market sectors, subsectors, rating categories, rating designations, outlooks, CreditWatch placements, and maturities. Issues included in the composite bond spread calculations have the following characteristics:

• Face amounts outstanding of at least $100 million;
• U.S. dollar-denominated issues of companies domiciled within or outside the U.S.;
• Rated by S&P Global Ratings;
• Issues that may have embedded call, put, and sinking fund options; and
• Fixed-coupon bonds, excluding convertible, step-up, and preferred securities.

Related Research

• Global Rising Stars Since 1995 Total 857, Nov. 7, 2019
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• Utility Fallen Angels Are Rising, Oct. 30, 2019
• To 'BBB', Or Not To 'BBB': Management Decisions Spur Most U.S. Corporate Downgrades To 'BBB', Sept. 5, 2019
• The 'BBB' U.S. Bond Market Exceeds $3 Trillion, May 29, 2019
• From Underdog To Top Dog: Charting The Growth Of 'BBB', April 26, 2019
• The U.S. Speculative-Grade Market Can Withstand 'BBB' Downgrades, April 24, 2019
• When The Cycle Turns: 'BBB' Downgrade Risks In EMEA Nonfinancial Corporates Appear Manageable, April 15, 2019
• The Cost Of A Notch, March 26, 2019
• When The Cycle Turns: 'BBB' Downgrade Risks May Be Overstated, Dec. 3, 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: U.S. 'BBB' Corporate Profiles Remain Firm Despite Rising Debt, July 25, 2018