Peering over the ratings cliff
We focus on the information contained in the rating transition probabilities within the BBB/BBB- and BB/BB+ rating cohorts with a view to identifying potential fallen angels and rising stars.
In our previous GFICC (Global Fixed Income Currency & Commodities) blog publication we used our proprietary forward-looking rating transition scores and their associated hit rates1 to construct forward-looking annual rating transition matrices in the US investment grade and high yield corporate credit markets. We now look at the current 12-month-ahead rating transition probabilities in the BBB/BBB- and BB/BB+ rating cohorts, analysing how they compare to annual historical rating change outcomes and applying these probabilities to our security selection process.
A focus on the fallen angel rating cliff
The fallen angel rating cliff is important for many investment grade credit mandates, including insurance mandates.2 Whilst the BBB/BBB- rating cohort is attractive from a spread carry perspective, one would like to be able to sell their downgrade-susceptible bonds in this cohort ahead of their composite rating downgrades to high yield. In doing so, investors would avoid three potential issues:
- Breach of investment grade fund mandate guidelines;
- Having to sell around the rating change event, at the time when every other investment grade-only holder would look to sell;
- Increased solvency-related capital charges being levied on insurance portfolios.
How does the information embedded within the current predictive rating transition matrix look, and how does it compare with annual historical rating change outcomes? Figure 1 shows the percentage of realised annual upgrade and downgrade outcomes in the US BBB/BBB- rating cohort.3 In accordance with historical outcomes in the broader investment grade universe, the lowest upgrade/downgrade ratios occurred in 2020, the year that the Covid-19 pandemic started. Subsequently, the peak in the upgrade/downgrade ratio in the current year to date is mainly driven by positive outcomes in the Communications and Consumer sectors.
Figure 1: Rating upgrade and downgrade events: US BBB/BBB- rating cohort
The “Prediction” data to the right in Figure 1 depicts the upgrade and downgrade summary statistics from the 12-month-ahead rating transition matrix as of 15th June 2023. These bars show that the current forward-looking rating picture within the US BBB/BBB- cohort looks balanced, with roughly the same probabilities being attached to upgrade events and downgrade events over the next 12 months; the forecast upgrade/downgrade ratio in this cohort is 1.04.
Bonds with high rating transition scores are more likely to be upgraded, whilst those with low scores are more likely to be downgraded. Bonds with neutral rating transition scores can be characterised as relatively stable. Hence, by selling down the potential downgrade candidates, one may maximise spread carry in the BBB/BBB- rating cohort whilst offloading the bonds that are most likely to attain high yield status over the next 12 months. From Table 1 a case can be made for shifting some allocation from the bucket of strong potential downgrade candidates to, say, the bucket with ratings-neutral candidates. There will, of course, be some degree of spread carry loss but, on the positive side, one would be avoiding potential downgrade candidates ahead of their downgrade events.
Using rating transition matrices to predict rising stars
As well as wanting to avoid potential fallen angels, investment grade credit investors sometimes seek insight on high yield bonds that are potential rating upgrade candidates, known as “rising stars”. Some investment grade mandates do permit holdings in high yield debt.4 To this end, we can use our proprietary forward-looking rating transition framework to analyse the behaviour of the US BB/BB+ combined cohort and identify potential rising stars within it.
Figure 2 shows the percentage of realised annual upgrade and downgrade outcomes in the US BB/BB+ rating cohort. In accordance with the broader high yield universe, the historical pattern depicts a high number of downgrades in 2020. The recovery period, 2021 and 2022, saw more upgrades than downgrades, mainly driven by positive outcomes in the Energy and Consumer Non-Cyclical sectors. The Energy sector has also driven the upgrades in the current year to date.
Figure 2: Rating upgrade and downgrade events: US BB/BB+ rating cohort
The “prediction” data to the right in Figure 2 shows that the current forward-looking rating picture within the US BB/BB+ cohort looks positively skewed, with higher probabilities attached to upgrade events than downgrade events over the next 12 months; the forecasted upgrade/downgrade ratio in this cohort is reasonably high at 1.41. It would be fair to say that all three of the underlying rating drivers – namely rating momentum, index methodology composite rating bias and credit watch flag – contributed towards these results.
Investment grade investors can potentially gain an edge by identifying and selling the bonds with the highest probability of becoming fallen angels. Likewise, they can also, in some investment mandates, proactively invest in rising stars within the BB/BB+ rating cohort of the high yield transition matrix. In both cases, acting ahead of the predicted bond composite rating changes could be beneficial for spread dynamics—the spreads of potential fallen angels would likely continue to widen in the lead up to their rating downgrade events, whilst the spreads of rising stars would likely continue to tighten as they entered the investment grade universe.5
Finally, within insurance mandates, there is a direct application of rating transition probabilities to the measurement and projection of solvency-related capital charges—insurance money managers may certainly benefit from being forewarned about the likely rating behaviour of individual bonds around their rating cliffs and the consequent changes in capital charges they would incur should the projected downgrades or upgrades materialise.