Published on Mar. 20, 2020
Our Thoughts On The Potential For BBB Downgrades
When credit rating agencies assign credit ratings to issuers, the credit analysts generally consider the resilience of the underlying business and that business’s ability to service its debts through a business cycle contraction. A heightened probability of recession alone may not be reason enough to prompt a wave of rating downgrades. That said, we believe every economic market cycle is different, and a sudden falloff in economic activity from a rapidly spreading pandemic is most likely not the recession case broadly modeled by credit analysts when ratings were assigned.
Industries caught in the crosshairs of the Covid-19 pandemic, and companies experiencing outsize revenue or supply chain impacts beyond a typical recessionary episode, might be vulnerable to credit ratings downgrades. This may be particularly impactful for those issuers rated BBB-, the lowest rung of investment grade, as a downgrade would catapult them into junk status. In the current situation of stress across the capital markets, investors in these bonds could see their positions materially repriced.
An important offset may be government-directed fiscal relief. Historically these types of packages have supported the creditworthiness of their recipients, and we expect the rating agencies will take this into account when determining whether an impacted company still merits a lower investment grade rating. While Congress has passed two bills thus far designed to provide relief for Americans, there are ongoing negotiations over a third larger bill which may include industry-specific bailout packages. However, we do not know at this time what form any such packages may take, and which firms they may cover.
The Current Income Portfolio mostly manages credit risk on a sector basis by largely avoiding those areas it deems weakest, consistent with seeking attractive yields while preserving investor capital. Broadly speaking this has led the portfolio to enter this episode underweight or largely unexposed to the energy and retail sectors, which struggled to overcome secular headwinds during the economic expansionary period. Its exposure to travel and automotive manufacturing is similarly limited in nature.
With respect to large banks, where CIP does have material exposure, we see several crosswinds. The benign credit conditions banks have experienced for many years appear to be coming to an end, and we expect borrower delinquencies will increase materially in the coming months. Moreover, the new current expected credit losses (CECL) accounting standard will require banks to accelerate their recognition of credit losses as the economic outlook worsens. That said, many banks enter this period holding substantial capital. We believe that they have been careful to limit lending to the energy sector following the similarly steep crude oil price declines that occurred just four years ago. Many broker-dealer businesses have experienced an uptick as clients race to hedge exposures in these volatile markets. Overall we believe large banks are well positioned to weather the storm, and we expect them to hold sufficient capital and liquidity to retain their investment-grade ratings, as these are an important source of confidence for their clients, as well as a way to access low-cost funding.