Apr. 15 2019 — During the next credit crunch, will the markets be able to absorb the debt that moves down to speculative grade? This has been increasingly on the minds of investors because of the very large increase in debt at the lowest category of investment grade. According to S&P Global Ratings' estimates, gross reported debt of nonfinancial corporates based in Europe, the Middle East, and Africa (EMEA) rated in the 'BBB' category has surged by 80%, or about $1.0 trillion, since 2007 to about $2.2 trillion at year-end 2018. The largest single driver was about $1.5 trillion of debt downgraded into the 'BBB' category from higher ratings.
There are many reasons for these downgrades, including company-specific factors, but we believe the most common thread is increasing risk tolerance by companies. Many issuers believe 'BBB' is a more efficient rating in terms of optimal capital structure, balancing their efforts to reward shareholders and engage in debt-financed M&A, while maintaining an investment-grade rating--though at the lower end of that range. (Ratings down to 'BBB-' are considered to be investment grade, while ratings of 'BB+' and lower are speculative grade.)
In aggregate, the growth of the "Triple Bs" poses a risk of credit market disruption if a large proportion of these issuers are downgraded during the next global recession or credit cycle downturn and if the high-yield or leverage loan markets cannot absorb a large amount of so-called "fallen-angel" debt. Some traditional holders of 'BBB' rated debt could become forced sellers, depending on their investment mandate, and borrowing costs for 'BBB' and 'BB' category issuers could rise. There is also a concern that a rapid expansion of speculative-grade issuers could crowd out those toward the bottom end of the credit spectrum, making it harder for 'B' or 'CCC' category issuers to refinance maturities.
On the basis of historical downgrade rates, up to $250 billion of debt borrowed by 'BBB' rated issuers could be lowered to speculative grade in a severe downturn, although this is not our forecast for the next one-to-two years. This equates to about 10% of the $2.2 trillion of 'BBB' issuer debt outstanding and 20% of the $1.3 trillion of debt we estimate is outstanding by speculative-grade rated nonfinancial corporates based in EMEA. This market has been able to accommodate sizable downgrades in the past without notable disruption, and while this would have some effect on borrowing costs, we consider this amount in itself to be manageable.
There are a number of reasons why we think the amount of fallen-angel debt will be below this level during the next couple of years. Firstly, we do not expect the next downturn to be as severe as the 2008/2009 financial crisis. Additionally, there is industry sector diversity and lack of overlap of these company's businesses, and generally moderate leverage among 'BBB' category issuers.
Nevertheless, there is a high level of concentration among the most sizable 'BBB' category rated issuers, with the 20 largest accounting for about 40% of the $2.2 trillion total. Should we downgrade some of them into the 'BB' category, there would likely be far more market risk.
Here, we dive deeper into S&P Global Ratings' data and credit metrics for 'BBB' rated nonfinancial corporates in EMEA to size the potential downside risks, identify the key drivers of the growth of debt in the 'BBB' category, assess leverage trends, split out key industry sectors, identify the largest 'BBB' category borrowers, and explain historic downgrade levels.