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Economic recovery fuels record pace of rating upgrades

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Brian Cheung joins Myles Udland to discuss the companies experiencing rating upgrades due to the recovery and the factors contributing to the record amount of net upgrades over the last three months.

Video Transcript

MYLES UDLAND: All right, class is in session. Professor Brian Cheung stopping by for a chart of the day, digging in a little bit more deeply on something we don't talk about too much here on this program-- the credit markets. Brian.

BRIAN CHEUNG: Well, you know, Queen Bee herself, Beyonce, once said, let me upgrade you. And the same trend is kind of playing out in the investment grade corporate debt market. A little bit of a stretch there, but what you're looking at right here is coming from Bank of America. And this is showing record net upgrades over the last three months, specifically in the investment grade credit markets.

So again, we don't talk too much about corporate bonds, but a very interesting trend going on right here, where you're seeing $115 billion in net upgrades in June. That was already after a record $128 billion in upgrades specifically in the investment grade space in May. And this is for a number of reasons. When you think about earnings beats, the bar was low on Wall Street for a lot of corporate earnings across the board.

And then, secondly, it may have just been that credit agencies were way too bearish in the depths of the pandemic. The amount of downgrades that we saw in the depths of the pandemic last spring may have been one major reason why we're seeing that springboard back up. And what's interesting, though, is that in context, you can see that actually the rating downgrades were more harsh in the pandemic than they were in the 2008 and then also in the midcycle recovery after that last financial crisis.

Now I want to show you an example of what's been going on in this space with two specific companies. They're really tied together. VMware, a software company, they actually just announced a $6 billion bond offering. And that's in connection with the spin-off that they are having from Dell, which was announced earlier this year. Now they want to use this to pay off some dividends and also pay down some debt.

But keep in mind, VMware is an IG company. They're rated BBB. Dell is a junk bond company. They're rated at BB, or if you want to call it, speculative or non-investment grade. I guess you could use those as euphemisms as well. But it just underscores how $6 billion, just announced yesterday in bond offerings, these are rising stars that could be taking advantage of this very healthy corporate debt market, guys.

MYLES UDLAND: Yeah, you know, Brian, I think what's also interesting about the debt market and just some comments we got today from Blackstone CEO Jon Gray, saying that across their 2,000 borrowers in their credit area, they had one default. And I sort of wonder about just the relationship that rating agencies have with the business cycle at this point, the amount of liquidity that's in the system, the amount of liquidity that came into the system. Like, is the risk of default being overpriced even when we look at some of this data?

BRIAN CHEUNG: Absolutely, but I think that the one factor that we haven't talked about is the Federal Reserve. And we have to acknowledge that they stepped in, in the midst of the pandemic last year with something that they had never done before, which is backstopping the corporate debt market through its primary and then secondary market corporate credit facilities.

Again, the Federal Reserve didn't even do that in the 2008 recession. And this is a big reason why. You saw these credit agencies taking down the ratings on a number of these companies because that's how concerned, not just the credit rating agencies, but I think markets across the board were about a lot of these companies going bankrupt.

Now, of course, whether or not this is going to inflate the debt bubble among all these companies, a lot of debate about whether or not this is helping to prop up zombie companies, but regardless, the Federal Reserve doing what they did last year to do that, I think is a big reason why we're seeing some of that bounce back and also the reason why we saw some of that pessimism in the depths last year as well.

MYLES UDLAND: Yeah, look, I know-- Brian, I know you're a credit rating agencies homer, so, you know, it's going to be--

BRIAN CHEUNG: I am an S&P alum for full-- yeah.

MYLES UDLAND: You are a ratings agency homer.

BRIAN CHEUNG: For full disclosure, yeah.

MYLES UDLAND: But I will say that when you just look at how much capital is in private markets, one wonders just how much the rating agencies are impacting pricing in the new market, where people can just say, well, I disagree, and I'll buy this for four, six, eight, 10, 12 times EBITDA just because I feel like it, and I have to deploy this capital. Otherwise, I have to give it back to my LPs. But we will table that conversation for another time. Brian Cheung stopping by for a chart of the day.