In the Ernest Hemingway novel The Sun Also Rises, Mike is asked how he went bankrupt. “Two ways,” he answers. “Gradually, then suddenly.”

COVID-19 seems to have rewritten the financial rules: Central Banks are pushing interest rates further into negative territory and Government support for businesses and their employees has pushed Sovereign debt to levels not seen since the Second World War.

But in the real world, fundamentals still matter. The bankruptcy list lengthens every week, and growing numbers of “Fallen Angels” show that many more firms are likely to suffer the same fate before the crisis is over.

The boundary between investment grade (IG) and non-investment grade (non-IG) borrowers, is traditionally defined by agencies and bond markets such that anything rated at BBB- or better is IG, anything at BB+ or worse is non-IG. Consensus credit data suggests that, in normal circumstances, this boundary corresponds to an approximate forward-looking default risk of 50Bps per annum, or 1 in 200.

Figure 1 shows proportionate yield changes in each credit category over the crisis period (end-February to early August).

Pre-crisis, the median downgrade rate was about 2%; during the crisis, it has been in the range of around 3% (c category) to 7% (the other Non-Investment Grade categories). The aa category is just over 6% while the a and bbb+ categories are just over 4%. The bbb and bbb- categories are also close to 7%.

This suggests a possible boundary between the bbb+ category and the other bbb categories, with bbb+ close to the a- category rate, and bbb/bbb- similar to the bb and b category rates. This effect is observed consistently for every month between February 2020 and June 2020 inclusive[1].

If this trend continues, it implies that companies within the BBB bond issue categories will show divergent credit trends; the current “Solvency Boundary” may have moved, lying between the issuer risk categories of bbb+ and bbb.

This has important implications for bond and equity investors: in the current environment, not all BBB issues are the same. Investors need to look at the issuer risk level in detail if they want to remain on the safer side of the solvency boundary.

[1] Note that this would be consistent with the over-rating problem recently identified by Professor Ed Altman.