The significant rise in low investment-grade U.S. corporate debt may not equate to greater fallen angel risk in the next downturn, according to Fitch Ratings. Some of the rise is due to M&A accompanied by EBITDA growth and some is attributed to rising stars and issuers maintaining low investment-grade ratings through the current cycle, while prudently taking advantage of lower borrowing costs. Credit ratings are meant to withstand cyclicality with forward looking views considering financial flexibility and incorporating realistic forecasts of future operating performance but ratings can change because of management missteps, unforeseen events or deeper-than-expected downturn conditions. 

In a recently published special report "The Rise of 'BBB' Rated Corporate Debt - Examining the Risk of Fallen Angels in the Next Downturn", Fitch looked behind the numbers to address investor concerns about potential downgrades to high yield during the next downturn. For instance, about 70% of issuers in the Barclays Investment-Grade Index since 2012 increased debt but only about 45% experienced an increase in leverage of at least 0.25x. For Fitch-rated 'BBB' category issuers, there was a 0.40x increase in total debt/EBITDA over the past five years.

Fallen angel risk may not be as widespread as some anticipate in the next downturn due to varying credit stories across issuers, Fitch said. As of year-endc2018, approximately one-fifth of 'BBB' and 'BBB-' Fitch-rated issuers had leverage above our potential downgrade thresholds, with most being REITS, food, beverage and tobacco, and building materials and construction companies. We expect this percentage to decline to 15% in 2019 and 5% in 2020 due in most cases to post-acquisition deleveraging. 

"Our rating approach for strategic M&A has not changed, as the mix of rating actions over the past five-year period does not exhibit any particular trend," Fitch noted. "We generally expect credit metrics to return to levels consistent with the rating within two years of transaction closing. However, poor timing of acquisitions can compound the effects of a stressed operating environment because the pace of deleveraging is delayed leading to unexpected negative rating actions.

We believe most low investment-grade companies are well positioned to maintain ratings through a downturn due to relatively solid financial flexibility. Many low investment-grade-rated companies have picked a spot on the ratings scale by taking advantage of the historically low cost of debt capital during this credit cycle to issue debt to fund strategic M&A, dividends and other payments to shareholders. Therefore, many of these companies should have flexibility to avoid ratings downgrades during the next downturn by reducing cash spent on these activities and redirecting it to balance sheet preservation type activities."