The coronavirus crash has pushed a group of quality companies to the cusp of disaster - and investors must now confront the 3 most dangerous letters in markets
- BBB-rated companies that are one credit downgrade away from junk status boomed during the economic expansion, thanks to cheap borrowing costs.
- Ratings agencies could soon downgrade many of these companies in light of the market turmoil and looming recession.
- Investors who bought these bonds for their quality would suddenly own junk and might face liquidity challenges if they decide to sell.
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Anyone who invests in credit markets automatically accepts two main risks.
The first is that the price of bonds may fall as interest rates rise. The second is that ratings agencies may slap downgrades on companies during periods of financial stress.
That second risk is now a reality for investors who flocked to buy BBB-rated companies during the economic expansion. Triple-B is the lowest rung of the investment-grade scale, and companies classified as such have balance sheets deemed just strong enough to command a quality credit rating.
Their status as investment grade - and perceived lower risk of default - means they can tap debt markets at cheaper rates. And during the past decade of historically cheap borrowing costs and low yields, investors were plenty eager to finance these companies.
But investors who bought these bonds knew that it only took one financial calamity to turn their investment-grade holdings into junk. Calamity has now been brought on by the one-two punch of an oil crash and a coronavirus pandemic that's slamming global demand.
In effect, credit rating agencies could soon respond by downgrading these companies to junk.
"Companies at the lowest investment-grade rating,'BBB', are likely to continue to attract market attention, and we could take rating actions on some companies in the more exposed industries," said a team of S&P Global Ratings analysts led by Alexandra Dimitrijevic in a recent report.
They added, "Unsurprisingly, the industries most affected by cuts in discretionary spending and containment measures are airlines, transportation, leisure and gaming, hotels and restaurants, and retail." Analysts at Bank of America were more specific, flagging Macy's and Ford as two large companies at risk of downgrades in the coming weeks.
Investors are already panicking
Anxiety about the prospect of downgrades is already showing up in markets, judging by exchange-traded funds that track the high-yield and investment-grade segments.
In times of market stress, one would expect junkier assets - represented by the iShares iBoxx $ High Yield Corporate Bond ETF - to underperform their higher-quality peers. However, this ETF has lost 11% this week, besting the iShares iBoxx $ Investment Grade Corporate Bond ETF that fell 14%.
It's an indication that investors are worried about BBBs losing their status and becoming so-called fallen angels.
If their fears become a reality, investors who bought fallen angels would face the choice of holding on to junk or selling. Pension funds are among the large investors that are mandated to own investment-grade assets, although they usually do not have to sell immediately after downgrades.
Still, these funds would be selling into a junk market that does not have a lot of liquidity to begin with, said Kathy Jones, the chief fixed income strategist for the Schwab Center for Financial Research.
The big questions that will be answered in the weeks ahead, she added, are about where the buyers will come from and the yield they will demand.
"We haven't really seen that price discovery yet for the new era that we're entering," she told Business Insider.
Expect 'carnage' in energy
BBB-rated bonds have lost $400 billion of their market value since March 6 and are now worth $2.6 trillion, according to data compiled by Bloomberg.
The main culprit is the energy sector, which had the unfortunate timing of an oil-price war starting as the coronavirus brought economic activity to a halt.
"Carnage" is how Rick Rieder, BlackRock's chief investment officer of global fixed income, described what is taking place in energy.
"There's a demand shock that's hitting oil prices, there's a political shock that's hitting oil prices, and then there's the structural oversupply," he told Business Insider in an exclusive interview. "My sense is there will be - almost no matter what - major restructurings in the energy space."