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'BBB' Downgrade Risks May Be Overstated

Highlights

- Ratings on U.S. nonfinancial corporate issuers in the 'BBB' category have performed well over the past 35-plus years, even during periods of economic stress.

- Sizing downgrade risk based on our scenario analysis indicates $200 billion-$250 billion in potential fallen angel debt in the next recession. While material, this would be in line with past cycles when viewed as a percentage of the speculative-grade bond market, although we recognize further risks include the timing and composition of downgrades.

- While every cycle is unique, we believe strong business fundamentals and cash flow generation will support future ratings performance.

- Risks are posed by the significant amount of 'BBB' debt, the sizeable debt burden of a handful of issuers, as well as small pockets of higher leverage.

- Still, debt tends to be concentrated among the most stable sectors and issuers, with the majority of 'BBB' issuers leveraged below 3x in 2018 and 2019.

Dec. 03 2018 — 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.

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