BBB corporate bonds, the lowest investment grade rating band in which a company's debt rating can reside, have now grown to make up more than half of the entire global investment grade (IG) market.
Since the financial crisis, the IG and BBB market in particular has experienced rapid growth as companies have issued debt to benefit from historically low borrowing costs.
Repayment of these debts is not a concern when economic growth is positive and companies are trading profitably.
But if and when the next recession occurs, there could be a cascade of "fallen angels", companies that are downgraded from IG to high yield (HY), swamping the smaller HY market and causing problems for investors as liquidity dries up and imperfect market clearing mechanisms struggle to cope.
But before we become preoccupied with potential disaster scenarios, it is useful to contrast BBB corporate bonds and Italian government debt. The BBB corporate space is composed of many companies, all with their own individual risk of downgrade.
Conversely, the Italian government and its debt is a single BBB unit. It falls and rises as one.
Given a choice, I am more comfortable with the $3tn BBB-rated US corporate bond market than the near-$3tn BBB-rated Italian sovereign debt market
The main concern around the rapid growth of the BBB market is that the next recession will see elevated volumes of 'fallen angels', as the evident weighting towards the lowest-rated end of IG markets suggests there are many firms that could easily be downgraded from IG to HY.
The key question, then, is what proportion of the BBB market is in danger of a downgrade when the cycle turns?
There is no "normal" attrition rate for BBBs falling into HY. The proportion of BBBs that have been downgraded has fallen towards historically low levels in recent years.
In fact, in the past few years we have seen net upgrades to BBB from high yield. But should the global economy slip into recession, as is increasingly predicted of late, this is not sustainable.
Worst-case estimates based on past recessions suggest we could see in excess of $260bn of USD BBBs downgraded to HY if downgrades spike.
But I would argue that many of the predictions of doom are exaggerated. As the BBB space has grown, a wide disparity of leverage can be seen in BBB corporates balance sheets.
While some BBBs are highly leveraged, many are only moderately indebted. Simply being BBB rated is not enough to assume a firm is likely to become a 'fallen angel'.
Many businesses are expected to go on something of a 'debt diet' in the near future, as the slow turning of the market cycle gives them time to wean themselves off of debt.
Debt remains relatively cheap by historic standards, allowing refinancing and extension of maturity dates which further strengthens balance sheets.
BBB bonds had their share of difficulty in 2018 which will have brought things into sharp focus for chief financial officers. With levers still to pull, IG is now much more robust than we might expect - for now.
Equities overweight down to 3%
Relates to 136 million transaction reports
Patience must be a watchword
MSCI has recently increased the Chinese A-share market's inclusion factor from 5% to 20%.
Change of objective