Book enthusiasts catapulted John Berendt's classic Midnight in the Garden of Good and Evil to iconic status. The nonfiction-novel hybrid spent 216 weeks on the New York Times bestseller list, longer than any book before or since, that is, unless you include the Bible. With estimated annual sales of 100 million, lifetime sales of the Good Book exceed five billion.
Berendt's second book may not have matched the success of Garden, but the title was unquestionably inspired by the best seller of all time. The City of Falling Angels dives into a different brand of decadence, that of the city of Venice. What few appreciate is the term ‘fallen angel' never appears in the Bible. The closest readers get is in the 10th Chapter of the Book of Luke: “And He said to them, “I was watching Satan fall from heaven like lightning.”
Of late, investors have been witnessing more than their fair share of angels being cast out of the Investment Grade (IG) firmament to the bond market's answer to the netherworld, that is, a high yield, or ‘junk' credit rating.
More than any single factor, the size of the market should place IG on investors' radar screens. Deutsche Bank tallies the size of the outstanding market ended January at $5.3 trillion, more than double 2007's $2.4 trillion. The bulk of the growth, meanwhile, has come from the lowest-rated segment of the market, or BBB on Standard & Poor's scale. Once the threshold to BB-rated and below is crossed, a given IG bond is branded a fallen angel.
BBB-rated IG debt issuance has skyrocketed, ending January at $2.2 trillion, up from $802 billion in 2007. Tellingly, the pristine end of the scale, bonds rated AA, has actually shrunk to $511 billion from $526 billion over the same period.
The very composition of the IG market has undergone tremendous change since the last time the credit cycle turned, which by all appearances it is doing now. The riskier tilt within the IG universe should raise a red flag for investors who should not accept calming historical comparisons to prior cycles at face value.
Set aside macroeconomic indicators for a moment. Based purely on the amount of extra compensation investors were receiving for owning IG bonds, the Federal Reserve knew it was playing with fire by hiking rates in December. In market parlance, this premium is called the spread, or the difference between a corporate bond and a comparable risk-free Treasury.
For some unfathomable reason, the Fed saw fit to begin the current rate hiking campaign with spreads at double the average level that prevailed at the onset of the past three hiking campaigns. In Morgan Stanley's estimation, IG spreads were at two percentage points on December 16th, twice the average of one percentage point at the inception of the rate hiking cycles of February 1994, June 1999 and June 2004.
