Corporate Credit Research | North America

October 5, 2018 11:00 AM GMT

Corporate Credit Research | North America

The Nature of the BBBeast

A consistent rule of thumb that we live by when looking for

problems in credit cycles: Follow the debt growth. BBB IG debt

outstanding has grown to ~$2.5trn today, a 227% increase

since 2009. Along these lines, we see elevated downgrade

activity as a "stress point" when the cycle eventually turns.

What has driven thegrowth? The majority of the increase in BBB debt in this

cycle stems from net issuance ($1.2trillion), followed by downgraded debt ($745

billion). Notably, the growth in BBB debt outstanding is not being skewed by a

single sector or a small part of the market. Yes, large issuers have grown

significantly.For example, the top 25non-financial BBB names have a total of

$685 billion in index debt (up from $257 billion in 1Q09). But the number of BBB

issuers has also increased by 60% since 2009, while all sectors have increased

BBB debt, large and small companies alike.

High debtgrowth has translated to high leverage: BBBs not surprisingly make up

the majority of the leverage "tail" in the IG market, with 31% of BBB debt in our

universe now leveraged at or above 4.0x. Our implied ratings analysis tells a

similar story, where ~55% of BBB debt would have a HY rating if rated based on

leverage alone. Meanwhile, interest coverage has declined steadily since 2014,

particularly for BBB issuers,vs. some recent improvement in interest coverage

for the A-rated universe.

Sizing up downgrades: In the last three broad downgrade cycles (1989-91,2000-

03,and 2007-09) 7-15% of the starting IG index size was downgraded to HY over

the full period. Based on the size of the market today, that would equate to

roughly $350-750 billion of total downgrades this time over a multi-year period.

But remember,half the market is already BBB rated, compared to just 27%

before the 2000-03 downgrade cycle. Adjusting for the size of the BBB index

over time, downgrade volumes in the next cycle could be even larger, moving the

range to $550 billion-$1.1 trillion.

Downgrades lagthe market: The good news is that this is not a story for today in

that the big wave of downgrades will likely not come until credit spreads are

much wider than they are rightnow, which will take time to play out. What

matters today, in our view, is that valuations are pricing in very few long-term

fundamental risks, with the BBB/A non-fin spread basis still near cycle tights.

And lastly, when thinking about other markets that could feel the effect as these

risks materialize down the line, remember that the BBB part of the IG index is

now ~2.5x as large as the entire HY index, with this ratio near record highs.

MORGAN STANLEY & CO. LLC

Adam S Richmond

STRATEGIST

Adam.Richmond@morganstanley.com +1 212 761-1485

Felician G Stratmann

STRATEGIST

Felician.Stratmann@morganstanley.com +1 212 761-1353

Vishwas Patkar

STRATEGIST

Vishwas.Patkar@morganstanley.com +1 212 761-8041

Frederick T Fuchs

STRATEGIST

Frederick.Fuchs@morganstanley.com +1 212 761-4839

Exhibit 1: Downgrades and net issuance have added

most to the BBB total ($bn) Evolution of the IG BBB Universe 3,500

3,000

1,155

228 387

322 2,470 2,500

2,000

1,500 282

1,000 770

500

0

745

Source: Morgan Stanley Research, FTSE Fixed Income LLC

Exhibit 2: Supply from above when the cycle turns: BBB

par outstanding now ~2.5x as large as the full HY index

($bn) BBB Par vs HY Par 4,000 300%

3,500 250% 3,000 200% 2,500

2,000 150%

1,500 100% 1,000 50% 500

0 0%

92 94 96 98 00 02 04 06 08 10 12 14 16 18

BBB Par HY Par BBB Par % of HY

Source: Morgan Stanley Research, FTSE Fixed Income LLC

Dueto thenature of thefixed incomemarket, theissuers or

bonds of theissuersrecommended or discussed inthis

report maynot becontinuously followed. Accordingly,

investors must regard thisreportas providing stand-alone

analysisand should notexpectcontinuing analysis or

additional reportsrelating to suchissuers or bonds of the

issuers.

Morgan Stanley doesand seeksto do business with

companiescovered in Morgan Stanley Research. Asa

result, investorsshould beawarethat thefirm mayhavea

conflict of interest thatcould affect the objectivity of

Morgan Stanley Research. Investorsshould consider

Morgan Stanley Researchas onlya singlefactor in making

their investment decision.

Foranalystcertification and other important disclosures,

refer to the Disclosure Section, located at the end of this

report.

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Introduction

The Growth in BBBs

BBB IG debt outstandinghas grown significantly in this cycle,a story most IG credit

investors know quite well.For example,at ~$2.5 trillion outstanding, BBB par has

increased 227% since the beginning of 2009. The majority of the increase in BBB debt

stems from net issuance ($1.2trillion), followed by downgraded debt ($745 billion).

Notably, the growth in BBB debt outstanding is not being skewed by a single sector or a

small part of the market. Yes, large issuers have grown significantly.For example, the

top 25non-financial BBB names have a total of $685 billion in index debt (up from $257

billion in 1Q09). But the number of BBB issuers has also increased by 60% since 2009,

while all sectors have increased BBB debt, large and small companies alike. In other

words, the increase has been broad-based across the market.

So what does this mean big picture? Credit cycles are always different from one to the

next. But a consistent rule of thumb over time that we live by when looking for

problems down the line:Follow the debt growth. Very simply,applying to the current

cycle, we think BBBs will be one (of a few) stress points when the cycle does turn.

Downgrade activity will likely be meaningful. And when thinking about other markets

that could feel the effect, remember the BBB part of the IG index is now ~2.5x as large

as the entire HY index.

The good news is that this is not a story for today, in that ratings downgrades tend to

lag the market. In other words, the big wave of downgrades will likely not come until

credit spreads are much wider than they are rightnow, which will take time to play out.

But more importantly,valuations are pricing in very few fundamental risks, in our view,

with the BBB/A spread basis still near cycle tights. Hence we remain up-in-quality.

In the report that follows, we walk through the drivers of the growth in BBBs in this

cycle and think about implications for credit markets when the cycle ultimately turns.

We start by walking through whathas driven the increase in BBB debt in this cycle.First,

after substantial growth for many years, BBBs now represent $2.5 trillion in par value

(or just over 50% of the IG index). Downgrades in the Financial space have helped to

propel this figure to all-time highs,a factor that we (and most investors) are not too

concerned about,given very healthy Financial credit quality this time around. But

Financials are only a small part of the story. Non-financial BBBs have also grown rapidly

in this cycle (+181% since 2009),now totaling $1.84 trillion, or 52% of the total nonfinancial market (37% of the overall index).

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Exhibit 3: IG BBBs now total $2.5tn; 50% of IG index

($bn) BBB Index Debt Growth

3,000 55%

90 92 94 96 98 00 02 04 06 08 10 12 14 16 18

Financial BBB Non-Fin BBB BBB % (RS) BBB Non-Fin % (RS)

Source: Morgan Stanley Research, FTSE Fixed Income LLC

Over the last few years, the growth in non-financial BBBs relative to the full indexhas

been moderated by strong issuance from companies with trapped cash overseas – a

cohort that tended towards highly rated names such as Apple, Microsoft, Cisco,and the

like. In other words, BBB non-financial debt was growing rapidly over this period, but so

was higher-rated non-financial debt. However, with these companies now issuing less

debt on account of repatriation reform, BBBs are once again growing faster than their

high-quality counterparts (Exhibit 2).For example,non-financial BBBs grew nearly 7%

y/y vs. only 1% growth in higher-quality names.Looking ahead, we expect this trend to

persist, with non-financial BBBs continuing to increase as a portion of the overall

market.

Exhibit 4: Higher-quality debt growth has recently trailed given repatriation, as BBB issuance

continues

40% Non-Financial Growth: BBBs vs Higher Rated 200%

Jan-09 Apr-10 Jul-11 Oct-12 Jan-14 Apr-15 Jul-16 Oct-17

BBB Y/Y HQ Y/Y BBB Cumul. (RS)

HQ Cumul. (RS) All Non-Fin Cumul. (RS)

Source: Morgan Stanley Research, FTSE Fixed Income LLC

Taking a step back, since the beginning of 2009, BBB par has more than tripled (3.3x),

while the indexhas more than doubled (2.4x) – a shift in ratings composition that we

can’t ignore. Breaking down this growth (Exhibit 5), we note that the majority of the

increase stems from net issuance ($1.2trillion), followed by downgraded debt ($745

billion). Rising stars brought in less than $300 billion of new index debt, offset by

approximately $300 billion of fallen angels.For a full breakdown of this analysis by

sector, see Appendix: BBB Debt Growth by Sector.

20%

25%

30%

35%

40%

45%

50%

0

500

1,000

1,500

2,000

2,500

0%

50%

100%

150%

0%

5%

10%

15%

20%

25%

30%

35%

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Exhibit 5: Downgrades and net issuance have added most to the BBB total

($bn) Evolution of the IG BBB Universe

3,500

770 745

282

1,155

228 387

322 2,470

0

500

1,000

1,500

2,000

2,500

3,000

Source: Morgan Stanley Research, FTSE Fixed Income LLC; Note: Downgrades / upgrades counted for debt outstanding in year of downgrade; issuance in subsequentyears, less maturities, included in “net” BBB issuance.

Within the "net issuance" cohort,a large portion actually comes from previously

downgraded issuers. In other words,after these companies get downgraded, in most

cases, they continue growing index debt outstanding. In particular, we find the largest

BBB capital structures in the market today, which have increased debt significantly in

this cycle, in many cases used to be higher rated.For example, $991 billion of BBB debt

in the index (40% of total BBB par) is associated with ~90 companies that were

downgraded into BBB since 2009. As we show in Exhibit 6,after Financials, Telecom and

Healthcare have the most BBB debt (which was previously higher rated), followed by a

combination of Consumer sectors.

Exhibit 6: Outside of Financials, Telecom and Healthcare have largest BBB debt loads at

companies that were previously “A” rated or higher

($bn) Current Non-Financial BBB Debt - 250 Companies Previously "A" or Higher

200

150

100

50

0

Source: Morgan Stanley Research, FTSE Fixed Income LLC

Looking again at all issuers (not just the formerly high-rated ones), we note that the

growth in BBB index debt is fairly widespread,not just coming from a handful of issuers.

First, while the largest BBB issuers are much bigger today vs.earlier in this cycle, there is

more BBB par in every debt-outstanding bucket (Exhibit 7).

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Exhibit 7: The biggest BBB issuers have gotten much bigger, but more BBB par in all debtoutstanding buckets today

0%

5%

10%

15%

20%

25%

30%

35%

40%

0

100

200

300

400

500

600

($bn) Total Non-Financial BBB Outstanding by Bucket

0 - 1,000 1,000 - 2,500 - 5,000 - 10,000 - 20,000 -

2,500 5,000 10,000 20,000 100,000

Total BBB Debt (2009) Total BBB Debt (Current)

% of Total Non-Fin BBB (2009)(RS) % of Total Non-Fin BBB (Current)(RS)

Source: Morgan Stanley Research, FTSE Fixed Income LLC; Note: Debt outstanding bucket measures the total BBB par outstanding today and in 2009

from issuers with total index debt outstanding in each respective range.

Second, the number of BBB issuers in the IG indexhas risen by about 60% since 1Q09

(Exhibit 8). Third, Exhibit 9 shows significant growth in non-financial BBB debt from the

Telecom, Healthcare, Tech, Consumer and Energy sectors, but all sectors have increased

BBB debt outstanding in this cycle.Fourth,at the median,non-financial BBB issuers have

seen their index debt load grow 56% since 1Q09, which would not be the case if only a

handful of largest issuers accounted for the full increase.

Exhibit 8: The number of BBB issuers has grown the most in Exhibit 9: ...But all sectors have seen an increase in BBB par

Financials and Tech... outstanding in this cycle

120 Number of Companies with BBB Debt 240%

($bn)

600

Par Value of BBB Debt

1000%

100

80

60

40

20

0

200%

160%

120%

80%

40%

0%

500

400

300

200

100

800%

600%

400%

200%

-20 -40% 0 0%

1Q09 Current % chng # 1Q09 Current % chng Par

Source: Morgan Stanley Research, FTSE Fixed Income LLC Source: Morgan Stanley Research, FTSE Fixed Income LLC

Lastly, we also examined the top 25non-financial BBB names in the index to help to

gauge how the markethas evolved over time. As Exhibit 10 shows, the top 25names

have a total of $685 billion in index debt (up from $257 billion in 1Q09) and median debt

of $20 billion (up from $9 billion in 1Q09) – growth rates in line with the broader nonfinancial BBB universe. Additionally, the top 25 still represent about a third of the total

non-fin BBB universe, the same level as in 2009. However, the composition has changed

significantly.For example, only 6 of the top 25 issuers from 2009 are still in the top 25

today and 7 of the names in today’s listhave resulted from downgrades. TMT and

Healthcare are again well-represented at the top, totaling $351 billion, or 51% of the top

25names,up from $104 billion in 1Q09. And we note that many of these issuers have

seen debt loads grow as a result of M&A,as we previously discussed in detail (see

Corporate Credit Research: M&Aking a Leveraged Balance Sheet,2018.08.10).

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- i i

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Exhibit 10: The top 25 non-financial BBB capital structures – today vs. Exhibit 11: Sector composition of the top 25 non-financial BBB names

2009 over time

Top Non F nanc al BBB Names

1Q09 Current

Rank Ticker Sector

BBB Par in

1Q09

Current

Rat ng Rank Ticker Sector

BBB Par

Current

Rat ng n

1Q09

1 CMCSA Media 25,540 A 1 T Telecommunication Services 81,912 A

2 TWC Media 17,154 BBB 2 VZ Telecommunication Services 75,772 A

3 TWX Media 14,952 BBB 3 CVS Consumer Staples 58,682 BBB

4 MDLZ Consumer Staples 13,800 BBB 4 GM Consumer Discretionary 37,848 Rising Star

5 EXC Utilities 12,484 BBB 5 F Consumer Discretionary 35,285 Rising Star

6 MO Consumer Staples 11,900 A 6 KMI Energy 29,360 BBB

7 DT Telecommunication Services 11,250 BBB 7 ETP Energy 27,294 BBB

8 TITIM Telecommunication Services 11,071 Fallen Angel 8 BATSLN Consumer Staples 24,959 BBB

9 FE Utilities 10,291 BBB 9 CHTR Media 23,839 New

10 KMI Energy 10,011 BBB 10 KHC Consumer Staples 22,445 BBB

11 FOXA Media 9,396 BBB 11 D Utilities 21,344 BBB

12 HD Consumer Discretionary 9,250 A 12 WMB Energy 20,781 BBB

13 BRKHEC Utilities 8,867 A 13 AGN Health Care 20,057 A

14 RIOLN Materials 8,850 A 14 EPD Energy 20,050 BBB

15 APC Energy 8,275 BBB 15 CELG Health Care 19,850 New

16 CTL Telecommunication Services 8,160 BBB 16 ABT Health Care 19,535 AA

17 XOM Energy 7,997 AA 17 VOD Telecommunication Services 17,945 A

18 PCG Utilities 7,980 BBB 18 MCD Consumer Discretionary 17,900 A

19 SUCN Energy 7,675 A 19 AVGO Information Technology 17,506 New

20 ARNC Industrials 7,639 BBB 20 PCG Utilities 17,505 BBB

21 WMB Energy 7,203 BBB 21 DELL Information Technology 16,250 A

22 EPD Energy 7,200 BBB 22 TWX Media 15,041 BBB

23 BRITEL Telecommunication Services 7,000 BBB 23 BDX Health Care 14,994 New

24 UNP Industrials 6,950 A 24 FOXA Media 14,989 BBB

25 AEP Utilities 6,950 BBB 25 DISCA Media 14,086 New

Top 25 Non-Fin BBB Capital Structures, by Sector

100%

50%

0%

09 10 11 12 13 14 15 16 17 18 Telecommunication Services Consumer Staples Energy

Consumer Discretionary Health Care Media

Utilities Information Technology Industrials

Materials Real Estate

Source: Morgan Stanley Research, FTSE Fixed Income LLC Total 257,845 685,229

Source: Morgan Stanley Research, FTSE Fixed Income LLC; Note: New entrants defined as those with no HY

debt prior to joining the IG index.

BBB Fundamentals

The growth in BBB debt outstandinghas naturally coincided with weaker fundamentals,

as one would expect.For example, in our IG fundamental universe of non-financial US

names, median BBB gross leverage is 2.55x,vs. 1.98x for As (Exhibit 12). Gross leverage

has ticked modestly lower very recently,as strong earnings growth and slowing debt

growth have helped at the margin, but absolute leverage levels remain quite elevated,

especially compared to past late-cycle environments. Meanwhile, interest coverage has

declined steadily since 2014, particularly for BBB issuers,vs. some recent improvement

in interest coverage for the A-rated universe (Exhibit 13).

Exhibit 12: Gross leverage elevated across the board, including for Exhibit 13: BBB interest coverage continues to weaken as As

BBBs improve

(x) (x) Gross Leverage Interest Coverage 3.50 20.00

0.50 2.50

92 94 96 98 00 02 04 06 08 10 12 14 16 18 92 94 96 98 00 02 04 06 08 10 12 14 16 18

IG AA A BBB IG A BBB

Source: Morgan Stanley Research, FTSE Fixed Income LLC, Bloomberg Source: Morgan Stanley Research, FTSE Fixed Income LLC, Bloomberg

Additionally, BBBs not surprisingly make up the majority of the leverage "tail", with 31%

of BBB debt in our universe now leveraged at or above 4.0x.

1.00

1.50

2.00

2.50

3.00

5.00

7.50

10.00

12.50

15.00

17.50

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2Q11 2Q18 2Q11 2Q18 2Q11 2Q18 2Q11 2Q18 2Q11 2Q18

0.00x-0.99x 1.00x-1.99x 2.00x-2.99x 3.00x-3.99x 4.00x+

Exhibit 14: 18% of IG debt has a BBB rating and is levered 4.0x or Exhibit 15: 31% of BBB debt, by par, has leverage of 4.0x or more

more

% of IG Debt in Each Leverage Bucket, by Rating

50% % of IG Debt in Each Leverage Bucket - by Rating 100%

90%

80%

70%

60%

40%

30%

50%

40% 20%

30%

20% 10%

10%

0% 0% AA A BBB 0.00x-0.99x 1.00x-1.99x 2.00x-2.99x 3.00x-3.99x 4.00x+

AAA AA A BBB Source: Morgan Stanley Research, FTSE Fixed Income LLC, Bloomberg

Source: Morgan Stanley Research, FTSE Fixed Income LLC, Bloomberg

Our implied ratings analysis tells a similar story (for details of this analysis, see

Corporate Credit Research: M&Aking a Leveraged Balance Sheet,2018.08.10), where

~55% of BBB debt would have a HY rating if rated based on leverage alone (Exhibit 16).

Breaking down the implied ratings of BBB companies only, we again see that Healthcare,

Telecom,and Consumer Staples (along with Energy) account for a large portion of the

debt with implied HY ratings (Exhibit 17).

Exhibit 16: 55% of BBB debt would have a HY rating based on leverage Exhibit 17: Healthcare, Telecom, and Staples have a lot of BBB debt

alone with an "implied" HY rating

Implied Ratings of IG Companies by Leverage Implied Ratings of BBB Companies by Leverage (by Par) 45%

60% (by Par) 40% 36% 35% 50% 35%

30% 40% 25% 30% 20% 20%

20% 15%

10% 10% 7%

0% 5% 1%

0%

Aaa Aa A Baa Ba B Caa

Cons. Disc.

0% 0%

Cons. Spls. Energy Health Care Industrials Tech

Materials Media Real Estate Telecom Utilities Actual Rating: Aaa Aa A Baa Source: Morgan Stanley Research, Moody's, FTSE Fixed Income LLC

Actual

Implied

Actual

Implied

Actual

Implied

Actual

Implied

Actual

Implied

Actual

Implied

Actual

Implied

Aaa Aa A Baa Ba B Caa

Source: Morgan Stanley Research, Moody's, FTSE Fixed Income LLC

Downgrade Risks Down the Line

It is important to remember that credit cycles are always different from one to the next.

But a consistent rule of thumb over time that we live by when looking for problems

down the line:Follow the debt growth. Very simply,applying to the current cycle, we

think BBBs will be one (of a few) stress points when the cycle does turn. Downgrade

activity will likely be meaningful.

Looking at the past three cycles as a guide, we note that broad downgrade waves tend

to last 2-4 years and tend to coincide with a recession at some point as well as with

elevated high yield defaults. Credit markets have also experienced "mini" downgrade

waves outside of recessions, but those have typically been narrower, concentrated

around just one or two sectors, such as Autos in 2005 and Energy/Materials in 2016.

7 
Sizingup the potential risk this time around, in the last three broad downgrade cycles

(1989-91,2000-03,and 2007-09) 7-15% of the IG index was downgraded to HY over the

full period (see Corporate Credit Insights: Revenge of the Fallen,2016.02.26). Based on

the size of the market today, that would equate to roughly $350-750 billion of total

downgrades this time over a multi-year period. But remember,half the market is already

BBB rated, compared to just 27% before the 2000-03 downgrade wave. Taking from a

prior analysis of ours (see Corporate Credit Research:Living the HY-Life,2017.07.28)

where we adjust for the size of the BBB index over time, downgrade volumes in the next

cycle could be even larger,as we show in Exhibit 18.

Exhibit 18: Assuming the downgrade rate remains the same as in the past, downgrade volumes

will be significant

Start End

Length

(Qtrs)

Net Fallen

Angel

Volume

($Bn)

% of BBB

Index

1Q '89 1Q '91 13 36 34% 850

1Q '00 3Q '03 15 199 45% 1,132

3Q '07 4Q '09 10 156 23% 587

Statistics for Fallen Angels

During Previous Credit Cycles "Implied"

Fallen Angels

for this cycle*

($Bn)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Source: Morgan Stanley Research, Bloomberg, FTSE Fixed Income LLC, Moody’s; Note: For the 2007 downgrade cycle, we estimate net fallen angels using

actual index data. For prior cycles, we use Moody’s data for fallen angels with a haircut for index-eligible debt relative to market size.*Implied fallen angels

are calculated by multiplying the proportion of fallen angels seen in previous cycles as a percentage of the BBB index, times the current BBB index par.

What are the specific implications for markets? At the least, the liquidity issues

experienced in early 2016, when Energy/Materials companies were getting downgraded

at a rapid rate, will come back at some point – pushing credit markets (both IG and HY)

to valuations that don’t make sense fundamentally for short periods of time,as we saw

back then. In our view, those liquidity challenges come from four drivers: 1) Credit

markets have grown significantly in this cycle.2) A large volume of bonds will have to

change hands at some point, discussed in the downgrade analysis above. As we show in

Exhibit 19, the BBB par outstanding in the IG index is now ~2.5x as large as the full HY

index.3) The buyer base of US credithas shifted in this cycle, with a greater percentage

of bonds now held by mutual funds/ETFs and by foreign investors, which may impact

the stickiness of the flows into or out of US credit as spreads are widening (a topic for

another time). And lastly 4) the capacity to absorb risk on the way down is modest, with

dealer balance sheets much smaller than pre-crisis levels.

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Exhibit 19: Supply from abovewhen the cycle turns: BBB par outstanding now ~2.5x as large as

the full HY index

($bn) BBB Par vs HY Par 4,000 300%

92 94 96 98 00 02 04 06 08 10 12 14 16 18

BBB Par HY Par BBB Par % of HY

Source: Morgan Stanley Research, FTSE Fixed Income LLC

The good news is that this is not a story for today in that ratings downgrades tend to

lag the market. In other words, the big wave of downgrades will likely not come until

credit spreads are much wider than they are today, which will take time to play out.

Again, the mini downgrade cycle in 2016 provides a good example, where spreads began

widening in the middle of 2014 and the big wave of Energy downgrades didn’t peak until

early 2016 almost two years later.

Exhibit 20: Downgrades lag the market – expect spreads to move first

0%

50%

100%

150%

200%

250%

0

500

1,000

1,500

2,000

2,500

3,000

3,500

($bn) US Net Fallen Angels vs HY Spreads (bp)

86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16

200

300

400

500

600

700

800

900

(100) 1,000

(75)

(50)

(25)

0

25

50

Rising Stars Fallen Angels

Rising Stars - Fallen Angels HY Spreads (RS - Inverted)

Source: Morgan Stanley Research, Moody's, FTSE Fixed Income LLC

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Addressing the Pushback

Lastly, we finish by addressing two points of pushback that we often get to this analysis.

First,and most importantly, we hear that better earnings growth will drive lower

leverage and help to alleviate these BBB risks. In our view, better earnings growth helps

at the margin, without a doubt. And leverage has ticked modestly lower over the past

two quarters along these lines. But as we have seen in past cycles, companies won’t

delever in a big way until they are forced to through a credit cycle,especially when

confidence is booming. More importantly, regardless of small changes in credit metrics

at the margin, we believe the damage is already done. IG leverage is atunprecedented

levels vs. pastnon-recessionary environments,and we now have ~$2.5 trillion of BBB

rated IG debt, builtup over nearly a decade. These dynamics won’t change dramatically

on the back of a year of strong earnings growth.

Second, we often hear that the risk in IG is in higher-rated credits, which have more of an

incentive to increase leverage. While we don’t disagree that the incentive to move from

A to BBB may be higher than the desire to move from BBB to BB, leverage has risen

across ratings buckets in this cycle.For example, we recently wrote abouthow M&A has

driven big increases in leverage and BBB debt outstanding. And while these companies

may pledge to delever over time, those promises often don’t materialize even in a

healthy economy. In a downturn, when earnings roll over, the ability to maintain an IG

rating for 3and 4x+ levered companies will be even tougher, regardless of the desire to

remain IG.

Fundamental risks aside, our preference for As over BBBs is more about what is in the

price. In short,as we show in Exhibit 21, the basis between BBB and A industrials is

basically at cycle tights. Hence the cost of movingup-in-quality is still quite low.

Exhibit 21: The market is still not paying investors appropriately to own beta

(bp) BBB-A Industrial Spread

350

300

250

200

150

100

50

0

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Source: Morgan Stanley Research, FTSE Fixed Income LLC

Additionally,as we show in Exhibit 22and Exhibit 23,even if one could make the case

that downgrades from A to BBB will be larger in magnitude than the volume of

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downgrades from BBB to BB, the cost of the former is much lower than the cost of the

latter. As we show in Exhibit 22, leadingup to and shortly after a downgrade within IG,

spreads often widen by ~25bp.Leadingup to a downgrade from IG to HY, on the other

hand, spreads have historically widened by ~300bp. And as a sidenote, this chart also

shows that most of the spread widening around a downgrade (especially a fallen angel)

is done by the time the downgrade actually happens.

Exhibit 22: The cost of a downgrade from A to BBB is ~25bp at the Exhibit 23: The cost of a downgrade from IG to HY is ~300bp at the

median median

(bp) (bp) Cost of Downgrade: A to BBB Cost of Downgrade: Fallen Angels

20 100

15 50

10 0

(50) 5

(100) 0

(150) (5) (200)

(10) (250)

(15) (300)

(20) (350) T-4 T-3 T-2 T-1 T+0 T+1 T+2 T+3 T+4

T-12T-11T-10

T-9T-8T-7T-6T-5T-4T-3T-2T-1

T+0T+1T+2T+3T+4

Months Before / After Downgrade into BBB Months Before / After Downgrade into HY

Source: Morgan Stanley Research, Bloomberg Source: Morgan Stanley Research, Bloomberg

11 
Appendix: BBB Debt Growth by Sector

Exhibit 24: Financials (ex-Real Estate)

($bn) Evolution of the Financials IG BBB Universe 800

700 45 88 71 600 543 182 500 37

400

300 357 200 81 100

0

Source: Morgan Stanley Research, FTSE Fixed Income LLC

Exhibit 26: Healthcare

($bn) Evolution of the Health Care IG BBB Universe 250 16 20 198 200 19

150 122

16 100

50 56 19

0

Source: Morgan Stanley Research, FTSE Fixed Income LLC

Exhibit 28: Consumer Staples

($bn) Evolution of the Consumer Staples IG BBB Universe 300

250 23 30 223

200 8

148 150

6 100 72 12

50

0

Source: Morgan Stanley Research, FTSE Fixed Income LLC

Exhibit 25: Energy

($bn) Evolution of the Energy IG BBB Universe 500

450 26 32 400

350 311 90 177 300

250

200 58 119 150 52 100

50

0

Source: Morgan Stanley Research, FTSE Fixed Income LLC

Exhibit 27: Telecommunication Services

($bn) Evolution of the Telecommunication Services IG BBB Universe 300 3 250 226 6 21 66 200 19 150

105 100 58 50

0

Source: Morgan Stanley Research, FTSE Fixed Income LLC

Exhibit 29: Consumer Discretionary

($bn) Evolution of the Consumer Discretionary IG BBB Universe 250

15 20 200 27 180 71

150

64 100

46 32 50

0

Source: Morgan Stanley Research, FTSE Fixed Income LLC

12 
Exhibit 30: Industrials

($bn) Evolution of the Industrials IG BBB Universe 250

200 20 35

19 150 151 76

14 100 86 10

50

0

Source: Morgan Stanley Research, FTSE Fixed Income LLC

Exhibit 32: Information Technology

($bn) Evolution of the Information Technology IG BBB Universe 180

160 140

140 33 7

120 10

100 58 80 12 60

40 20 33 20

0

Source: Morgan Stanley Research, FTSE Fixed Income LLC

Exhibit 34: Media

($bn) Evolution of the Media IG BBB Universe 175 1 150 34 113

5

125 59

100 4 2

75

50

25

0

87

Source: Morgan Stanley Research, FTSE Fixed Income LLC

Exhibit 31: Utilities

($bn) Evolution of the Utilities IG BBB Universe 250 7

200 75 79

5 150

100 46 100

50

0

3

151

Source: Morgan Stanley Research, FTSE Fixed Income LLC

Exhibit 33: Materials

($bn) Evolution of the Materials IG BBB Universe 250

200 17 31

150 55

100 40

48 34 50

0

44 118

Source: Morgan Stanley Research, FTSE Fixed Income LLC

Exhibit 35: Real Estate

($bn) Evolution of the Real Estate IG BBB Universe 175

150

125 18 9

100

75 65

50 33 0 12 25

0

5

115

Source: Morgan Stanley Research, FTSE Fixed Income LLC

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COVERAGE UNIVERSE INVESTMENTBANKING CLIENTS (IBC) OTHER MATERIAL

INVESTMENTSERVICES

CLIENTS (MISC)

STOCK RATING COUNT % OF COUNT % OF % OF COUNT % OF

CATEGORY TOTAL TOTAL IBC RATING TOTAL

CATEGORY OTHER

MISC

Overweight/Buy 1178 37% 308 42% 26% 562 40%

Equal-weight/Hold 1378 44% 343 46% 25% 625 44%

Not-Rated/Hold 49 2% 5 1% 10% 7 0%

Underweight/Sell 554 18% 83 11% 15% 224 16%

TOTAL 3,159 739 1418

Data include common stock and ADRs currently assigned ratings. Investment Banking Clients are companies from whom Morgan Stanley received investment

banking compensation in the last 12 months. Due to rounding off of decimals, the percentages provided in the "% of total" column may not add up to exactly

100 percent.

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