It’s been a long time coming.

Last November, still smarting from a year he would rather forget, Russell Clark and his Horseman Capital, i.e. the “world’s most bearish hedge fund” unveiled what he would short next: according to Clark, the next major source of alpha would be shorting fallen angel bonds.

Citing a recent IMF Global Financial Report, Clark said that “US investment grade debt is very low quality, and could produce some large fallen angels [and] mutual funds are much larger in the high yield market than they used to be. [L]ow rates means the capital losses are much higher than they used to be. And that investors in high yield mutual funds are much flightier than they used to be! Essentially the IMF are telling me that if you get a large enough fallen angel, the high yield market will freak out, and volatility will spike causing volatility targeting investors to dump leveraged positions. Sounds good to me.”

Then, last June, one of the icons of credit and distressed investing, Oaktree Capital, joined the bandwagon of fallen angel hunters, saying that the fund “expects to see a flood of troubled credits topping $1 trillion as rising interest rates overwhelm low-quality loans and bonds.” Speaking at the Bernstein Strategic Decisions Conference, Oaktree Capital’s Chief Executive Jay Wintrob said that when the cycle turns it will be faster and larger than ever as “fallen angels” proliferate, and added ominously that “there will be a spark that lights that fire.”

Oaktree saw the potential opportunity as so pressing that the fund has now allocated about a quarter of its assets to troubled issuers: “Amid slim pickings in the U.S., the firm has looked to spread its distressed strategies into China, India and other emerging markets.”

To be sure, Horseman and Oaktree were not alone preparing for a surge in troubled issuers. The amount of “dry powder” held by fund managers to invest in low-quality debt has grown to around $150 billion, Wintrob estimated. Quoted by Bloomberg, he said this number has shown steady growth as the duration of bonds has increased, which could make the coming price drops even more significant than during the turn of the last credit cycle in 2008.

Meanwhile, the cadre of US bankruptcy advisors are ready: in late May we quoted Moelis’ co-head of restructuring Bill Derrough who said that “I do think we’re all feeling like where we were back in 2007,” adding that “there was sort of a smell in the air; there were some crazy deals getting done. You just knew it was a matter of time.”

A few weeks later, the attention of fallen angel hunters jumped across the Atlantic, when BofA’s Barnaby Martin estimated that there is now some €800 billion in European BBB bonds at risk of a downgrade.

The vast size, and risk, of this sector which is 2.5x greater than the entire high-yield market in Europe, prompted Martin to warn that the next Eurozone recession – or merely revulsion to bonds once the ECB stops monetizing debt – could be devastating to the continental bond market. As the BofA strategist warned, should a Eurozone recession become a more plausible event down the line, then the prospect of negative rating migration would have overwhelming consequences for the credit market in Europe, as the “the potential for such a vast amount of Fallen Angels (BBBs being downgraded to high-yield) at a time when Euro high-yield bonds are shrinking would cause enormous ructions and indigestion in the market.

Meanwhile, as we reported yesterday, the wheels are gradually coming off the European high yield market where spreads have blown out wider than US junk the most since 2012 …

… and it is only a matter of time before investors shift their focus, concerns and selling higher up the balance sheet, with BBB rated bonds next in line for a re-rating.

Fast forward to this week, when in a note from Morgan Stanley’s Adam Richmond, put it all together and warned that more than $1 trillion of investment grade US bonds could be cut to junk once the credit cycle turns, and warned that with US corporate spreads near record tights, investors aren’t being compensated for the risk.

As Richmond explains, a consistent rule of thumb that he has lived by when looking for problems in credit cycles: Follow the debt growth, and nowhere is it more obvious than in the outstanding amount of BBB investment grade debt which has grown to $2.5 trillion in par value today, a 227% increase since 2009, and just over 50% of the entire IG index.

To get a sense of just how large the risk of fallen angels in the US is, consider that like in Europe (see above), the BBB part of the IG index is now ~2.5x as large as the entire HY index. The majority of the increase in BBB debt in this cycle stems from net issuance ($1.2 trillion), followed by downgraded debt ($745 billion).

Downgrades in the Financial space have helped to propel this figure to all-time highs, a factor that we (and most investors) are not too concerned about, given very healthy Financial credit quality this time around. But Financials are only a small part of the story. Non-financial BBBs have also grown rapidly in this cycle (+181% since 2009), now totaling $1.84 trillion, or 52% of the total nonfinancial market (37% of the overall index).

Taking a step back, since the beginning of 2009, BBB par has more than tripled (3.3x), while the index has more than doubled (2.4x) – a shift in ratings composition that we can’t ignore. Breaking down this growth, the majority of the increase in BBB debt this cycle of the increase stems from net issuance ($1.2 trillion), followed by downgraded debt ($745 billion). Rising stars brought in less than $300 billion of new index debt, offset by approximately $300 billion of fallen angels.

Furthermore, the growth in BBB debt outstanding is not being skewed by a single sector or a small part of the market. Yes, large issuers have grown significantly. For example, the top 25 non-financial BBB names have a total of $685 billion in index debt (up from $257 billion in 1Q09) and median debt of $20 billion (up from $9 billion in 1Q09) . But the number of BBB issuers has also increased by 60% since 2009, while all sectors have increased BBB debt, large and small companies alike. However, the composition has changed significantly. For example, only 6 of the top 25 issuers from 2009 are still in the top 25 today and 7 of the names in today’s list have resulted from downgrades. TMT and Healthcare are again well-represented at the top, totaling $351 billion, or 51% of the top 25 names, up from $104 billion in 1Q09. Many of these issuers have seen debt loads grow as a result of M&A.

In light of the above, Richmond echoes Clark, Oaktree, Martin and many others, and warns that that “Along these lines, we see elevated downgrade activity as a “stress point” when the cycle eventually turns.

And turn it will, if for no other reason than because alongside the issuance deluge, leverage has also grown resulting in weaker fundamentals, and with rates now rising rapidly, it is only a matter before a tipping point hits.

Some more details: Morgan Stanley’s IG fundamental universe of non-financial US names has median BBB gross leverage is 2.55x, vs. 1.98x for As. Gross leverage has ticked modestly lower very recently, as strong earnings growth and slowing debt growth have helped at the margin, but absolute leverage levels remain quite elevated, especially compared to past late-cycle  environments. Meanwhile, interest coverage has declined steadily since 2014, particularly for BBB issuers, vs. some recent improvement in interest coverage for the A-rated universe. This is only worsen as rates keep rising.

Additionally, BBBs make up the majority of the leverage “tail”, with 31% of BBB debt in our universe now leveraged at or above 4.0x.

Why is this notable? Because according to Richmond’s calculations, a whopping 55% of BBB debt would have a HY rating if rated based on leverage alone: this is a staggering number and is greater than the current size of the entire junk bond marketBreaking down the implied ratings of BBB companies only, MS finds the that Healthcare, Telecom, and Consumer Staples (along with Energy) account for a large portion of the debt with implied HY ratings.

So what does this mean big picture?

Very simply, as a result of the tremendous debt growth and the decline in fundamentals in the current cycle, Morgan Stanley thinks BBBs will be one (of a few) stress points when the cycle does turn. Downgrade activity will likely be meaningful, and – as noted above – when thinking about other markets that could feel the effect, remember the BBB part of the IG index is now ~2.5x as large as the entire HY index.

First some perspectives from history.

Looking at the past three cycles, broad downgrade waves tend to last 2-4 years and tend to coincide with a recession at some point as well as with elevated high yield defaults. Credit markets have also experienced “mini” downgrade waves outside of recessions, but those have typically been narrower, concentrated around just one or two sectors, such as Autos in 2005 and Energy/Materials in 2016.

To evaluate the potential risk this time around, in the last three broad downgrade cycles (1989-91, 2000-03, and 2007-09) 7-15% of the IG index was downgraded to HY over the full period. Based on the size of the market today, that would equate to roughly $350-750 billion of total downgrades this time over a multi-year period. However, note that half the market is already BBB rated, compared to just 27% before the 2000-03 downgrade wave. So, adjust for the size of the BBB index over time, downgrade volumes in the next cycle could be even larger, rising as high as $1.1 trillion as shown below.

What are the specific implications for markets?

At the least, Morgan Stanley predicts that the liquidity issues experienced in early 2016, when Energy/Materials companies were getting downgraded at a rapid rate, will come back at some point – pushing credit markets (both IG and HY) to valuations that don’t make sense fundamentally for short periods of time, as we saw back then. Those liquidity challenges come from four drivers:

  1. Credit markets have grown significantly in this cycle.
  2. A large volume of bonds will have to change hands at some point, discussed in the downgrade analysis above. As we show in Exhibit 19, the BBB par outstanding in the IG index is now ~2.5x as large as the full HY index.
  3. The buyer base of US credit has shifted in this cycle, with a greater percentage of bonds now held by mutual funds/ETFs and by foreign investors, which may impact the stickiness of the flows into or out of US credit as spreads are widening (a topic for another time).
  4. the capacity to absorb risk on the way down is modest, with dealer balance sheets much smaller than pre-crisis levels.

However, while the $1 trillion in downgrades (worst case scenario) will roil the junk bond market, as demand tumbles once the total size of the market effectively doubles, leading to an explosion in bond spreads, the good news is that the big wave of downgrades will likely not come until credit spreads are much wider than they are today, which will take time to play out at least according to Richmond.

And while that may be good news, the only potential weakness with this analysis is that interest rates blow out at a much faster pace. Which in light of the dramatic blow out in yields last week, and the threat that it will continue, is becoming an increasingly greater threat. In fact, that may well be the the “spark” which Oaktree warned about in June, that lights that corporate bond fire and leads to the next US recession.

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