CCC Bond Quality Deteriorating to Pre-Crisis Levels: Goldman SachsVW Staff
As investors hungry for yield buy Indian junk bonds, Greek corporate debt, and anything yielding a few percent, many are warning of a bubble. The warnings usually come from perma bear pundits, or regular pundits but the sell side usually likes to be cheerleaders of markets rallies. However, Goldman Sachs takes a break with that tradition in a new report on CCC bonds (AKA junk bonds). Goldman notes that the credit risk premium on CCC bonds is now close to zero and that CCC bond quality is even worse than those before the financial crisis. Below is a summary followed by the full presentation from Goldman:
Goldman Sachs: CCC Bond quality and risk premium
The credit risk premium on CCC bonds is roughly zero Corporate spreads have continued their grind tighter over the last few weeks, and we now estimate that CCC cash bonds offer a credit risk premium close to zero. That is, holders of CCC bonds will be compensated for expected credit losses, but receive no additional premium for risking a larger loss.
We find arguments in defense of CCCs unconvincing
We investigate several arguments that have been made in defense of the current level of CCC bond spreads, and find them wanting. Compared to CCCs before the crisis, and contrary to suggestions we sometimes hear, we show that the current bucket: (1) is less concentrated in a few large names; (2) includes a lower percentage of CCC+ rated issues; (3) is no more likely to be on watch for an upgrade; (4) has similar issuer leverage and interest coverage ratios; and (5) features shorter maturities. We see no reason to lower our forecasts for CCC defaults and losses, which we expect to rise over the next several years, but to levels below their historical averages.
Although it is true that the largest name in the CCC bucket (TXU) accounts for about 6% of total face value outstanding, and the largest five names account for about 20%, this kind of concentration is not unusual. In 2007, for example, Ford Motor Company accounted for 11% of the bucket and the top five names for 28%.
About 60% of the face value outstanding in CCC is rated CCC+. Although this is a post-crisis high, it is still below the levels near 70% seen before the crisis. Less than 2% of CCC bond issues are on watch for an upgrade by Moody’s, which is not particularly high by historical standards. The fraction of issues on upgrade watch minus the fraction on downgrade watch is a bit above its historical average, but not by very much.
Ratios of debt to assets or to EBITDA in the CCC bond bucket are quite close to their precrisis levels, and so is the EBIT/interest payment coverage ratio. The ratio of cash to assets has risen somewhat, but not enough to change our view on the sector.
Average maturity in a CCC bond basket has actually shortened significantly in the last several years. The percentage of face value maturing in 3 years or less has risen to 14% today from 7% in 2007, and the percentage maturing in 5 years or less has risen to 37% from 24%.
Further reading- Goldman Sachs Prepares For A Bond Market Explosion