Uh-Oh, High-Yield Bond Downgrades Expand

Ratio to upgrades doubles, Moody’s says, due to sales dip.

Looking for impending trouble in the economy? There’s a new worry: Junk bonds, which suffer the most in a recession, are looking at a surge in credit-rating downgrades vs. upgrades.

According to Moody’s Analytics, the ratio of high-yield downgrades to upgrades has doubled—to 2.38:1 for January-September 2019, from 1.09:1 for calendar 2018. A revenue fall is to blame.

“A pronounced slowing by business sales, both with and excluding energy products, helps to the explain the marked excess of high-yield downgrades over upgrades after omitting primarily event-driven rating changes,” wrote John Lonski, the organization’s chief economist.

Sales growth, viewed as a three-month moving average and stripping out volatile (and lately in the tank) energy companies, slowed to 1.7% as of August, compared to a 5.6% pace the year before. During the last earnings deceleration in 2015 and 2016, the ratio soared to 3.44:1, way up from 0.99:1 in mid-2009, right after the Great Recession officially ended.

Overall earnings are on the downswing, which doesn’t bode well for bonds at the non-investment grade end of the scale. The FactSet consensus of analysts indicates a third straight year-to-year slide of 4.1% for S&P 500 earnings per share in the just-completed third quarter. 

A continued profit slide, in turn, likely could lead to a scramble into Treasury bonds, and this would widen the spread to junk. That would further harm the high-yield market.

“If core profits do not significantly surpass these downbeat forecasts, the 10-year Treasury yield may average something no greater than 1.7% through the end of 2020,” economist Lonski said. “And if a recession materializes, the bottom will fall out for Treasury yields and the benchmark 10-year yield probably slips under 1%.”

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