Rating agency Moody’s, having declared in June it "believes the debts of euro area sovereigns that are dependent upon funding from official sources represent non-investment grade risks", sparked a field day for conspiracy theorists when it maintained Spain’s Baa3 rating in mid-October.
The decision to maintain the country at investment grade was largely because "the risk of the Spanish sovereign losing market access has been materially reduced by the willingness of the European Central Bank (ECB) to undertake outright purchases of Spanish government bonds to contain their price volatility", according to the agency.
Its previous position was that such sovereigns should be rated sub-investment grade unless support is unlimited and unconditional, which any bailout of the country will not be.
The decision was met with some confusion and much relief, no more so than in the high-yield bond market. If the Spanish sovereign becomes sub-investment grade then there is a chance a number of large Spanish corporates could eventually follow.
Given that there is €47 billion of Spanish non-financial and €27 billion of Spanish financial high-grade debt, just a few Spanish corporates moving from investment grade to non-investment grade could have a substantial impact on the high-yield market – which is just €172 billion in size.
This prospect is still remote, given the number of notches by which ratings would need to be cut. Telefónica, the largest issuer, is rated triple-B/triple-B plus and would need to suffer a seven-notch cut to its composite rating to enter the high-yield indices.
However, with €16.5 billion of debt outstanding, it would immediately become the largest high-yield issuer in Europe and account for 6.94% of the index.
The Spanish corporate most at risk of being junked is Repsol – rated triple-B minus – which would need only a two-notch composite cut to become high yield. It has €5.7 billion of debt outstanding.
Despite the stay of execution at the end of September, a Moody’s downgrade of Spain is still likely. Indeed, the agency published a report on October 1 refuting the recent Oliver Wyman findings and stating that banks might need between €70 billion and €105 billion to meet capital ratios. S&P rates Spain three notches above junk and Fitch rates it two levels above – and both agencies have said a bailout would not trigger a downgrade.
If, however, the situation deteriorates to the extent that several Spanish corporates do fall below investment grade, the initial worry is the length of time it would take for such prolific issuers to be absorbed.
Telefónica, Santander and electric utility company Iberdrola would become the top-three issuers in the high-yield index, which in a worst-case scenario would grow by 43%. Many high-yield funds operate with a 3% constraint cap on single issuers, so the maths starts to look messy.
The ultimate losers could be the existing high-yield issuers, as investors dump their holdings to fill up on what are essentially good-quality corporates that have just found themselves in the wrong zip code. It might be hard to resist the temptation to kick out something to buy a fallen angel, such as Telefónica.
On the bright side, if a series of large corporates in peripheral European economies does enter the high-yield market, it will provide an important fillip to the asset class – closing the gap between the market and its $1.2 trillion US counterpart.
Expectations of forced selling might be overdone. Many investment-grade funds have been undertaking mandate revisions to deal with what would essentially be a technical downgrade, and one expert reckons only one-third of such funds might end up as forced sellers.
So, the market can take some comfort from the likelihood that the longer it takes for any sovereign downgrade to come, the weaker its impact on the corporate market will be.