Why the rate of fallen angel corporate bonds is ‘extremely low’

US companies are guarding their investment grade credit status, with relatively few of them slipping into riskier, high-yield tiers in credit rankings. The volume of US debt that’s been stripped of its investment grade rating, or fallen angels, has dropped to its lowest level in about 25 years, according to Goldman Sachs Asset Management.

In part, this shows how the surge in inflation helped many big American corporations manage their debt burdens. “The fallen angel rate in the US is extremely low,” says Stephen Waxman, head of the Global Investment Grade Research team in Goldman Sachs Asset Management. 

While some borrowers may, as is typical, be stripped of their investment grade status in the coming weeks and months, Waxman cites several reasons for investment grade ratings having been relatively buoyant overall. Borrowing costs have shot up, but many non-financial companies have fixed-rate debt that matures well into the future. The rise in interest rates has only had a modest effect for many firms.

At the same time, the US economy has grown steadily. In turn, earnings for many investment-grade companies have been rising, and nominal growth has been robust. Earnings before interest, taxes, depreciation, and amortization (EBITDA) has increased around 5% and may climb even more next year.

“The strong growth environment and conservative allocation of cash flows led to less debt being created on balance sheets,” Waxman says. “So we're not seeing that rapid debt creation to date, particularly over the last two years or so.”

Rising inflation may have benefited balance sheets

While there’s been much concern about the (now fading) jump in inflation since the Covid pandemic, some corporations with high-grade credit benefited from it. The impact of higher interest rates on their fixed-rate debt was diminished by higher nominal sales as prices increased.

“We like to say that corporations are nominal creatures,” Waxman says. “And so inflation actually helped a lot of companies. You had some very strong top-line growth rates.”

At the same time, some management teams reacted to the surge in interest rates by pulling back on expenditures like stock buybacks, which also helped burnish their credit metrics. “You normally only see this in a recession,” Waxman says. “Companies were just retaining cash flow.”

“We're now trying to understand whether that starts to reverse as nominal growth slows and as rates come down,” he adds.

There are also longer-term factors at work. Before the credit crisis of 2008, corporate managements were more willing to increase leverage and allow their companies to lose their investment-grade status. Some activist investors were more open to financing strategies that resulted in higher leverage than they are now.

There are indications that those trends have reversed to some extent. “The financial crisis chastened management teams,” Waxman says. Some activist investors are more focused on operational improvements, rather than financial engineering, than they were before.

Investment grade ratings are shifting below the surface

While many US companies are retaining their investment grade rating, there’s been movement beneath the surface. A number of borrowers have fallen from A to BBB status, one tier above the riskier high-yield ratings. But very few are descending from BBB to BB, one step below investment grade.

That’s partly a result of how companies navigated a period of more sluggish economic growth, between 2013 and 2019. Management teams were more focused on “in-organic growth” — activities like stock buybacks and mergers and acquisitions, Waxman says.

“You saw companies recognize that they didn't need to be so highly rated anymore, so long as they were somewhere in that mid BBB, or high BBB, category,” Waxman says. Companies in the telecom and beverage sectors, for example, borrowed money to fund acquisitions. Those deals increased their debt loads, but not so much that firms lost their investment grade ratings.

“It led to a dramatic growth in the BBB market,” Waxman says. The BBB rated set made up more than half of the investment grade bond market in early 2019 but has now declined to below 50%. These are often large companies that are less sensitive to fluctuations in the economy and have operational and financial flexibility.

“There was a lack of willingness to push the boundaries so far that you lost the investment grade rating,” he says.

How Fed policy and the US election will impact the market

Higher-rated companies are generally less sensitive to interest rates than companies with weaker balance sheets. For investment grade borrowers, the main implication of rate cuts by the Federal Reserve will be how that policy impacts the broader economy, Waxman says.

The US presidential election could be another near-term issue for the market. Waxman says market prices don’t appear to have adjusted for potential changes in policy from the federal government. “The market is still doing its homework. We are looking at it through a lens of taxes, trade tariffs, and regulation,” he says.

 

This article is being provided for educational purposes only. The information contained in this article does not constitute a recommendation from any Goldman Sachs entity to the recipient, and Goldman Sachs is not providing any financial, economic, legal, investment, accounting, or tax advice through this article or to its recipient. Neither Goldman Sachs nor any of its affiliates makes any representation or warranty, express or implied, as to the accuracy or completeness of the statements or any information contained in this article and any liability therefore (including in respect of direct, indirect, or consequential loss or damage) is expressly disclaimed.

Economic and market forecasts presented herein reflect a series of assumptions and judgments as of the date of this presentation and are subject to change without notice. These forecasts do not take into account the specific investment objectives, restrictions, tax and financial situation or other needs of any specific client. Actual data will vary and may not be reflected here. These forecasts are subject to high levels of uncertainty that may affect actual performance. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes. These forecasts are estimated, based on assumptions, and are subject to significant revision and may change materially as economic and market conditions change. Goldman Sachs has no obligation to provide updates or changes to these forecasts. Case studies and examples are for illustrative purposes only.

This content includes material from Goldman Sachs Asset Management, please click https://am.gs.com/en-us/advisors/about-us/general-disclosures for additional disclosures.