We believe the sharp increase in the proportion of BBB-rated constituents has made the investment-grade bond sector riskier than in recent years. BBB-rated bonds are typically the most vulnerable of all investment-grade debt in a recession. Any downgrade of such bonds would relegate them from the investment-grade universe to the high yield universe (making them “fallen angels”), which would negatively re-rate their value.
Analysis by Morgan Stanley has found that significant volumes of BBB-rated bonds were downgraded in previous credit downturns. In the 2007-09, 2000-03 and 1989-91 downturns, between 23% and 45% of investment-grade bonds were downgraded to junk. If downgrade rates were to remain at such levels, the next downturn could see approximately $600 billion of BBB bonds consigned to junk status.2