Fallen angels: The new high-yield bonds
21 May 2020 | Markets and Economy
A confluence of factors over the decade since the global financial crisis has steadily nudged the corporate bond market down the investment-grade quality scale. The Covid-19 pandemic threatens to knock some issuers off the scale completely.
Such companies and their bonds are known as "fallen angels", reflecting their descent from investment-grade to high-yield status. Their emergence creates higher financing costs for the issuers, changes in the composition of indices and the funds that seek to track them, challenges for high-yield markets that need to absorb them and opportunities for active funds.
"Although a downgrade represents an increased risk of default, if issuers can arrest some of the business pressures they face, fallen angels can end up being relatively high-quality bonds that everyone in the high-yield market wants to own, as some of them will be candidates for an upgrade to investment grade in the future," said Sarang Kulkarni, portfolio manager for Vanguard active global credit strategies.
How the investment-grade market has changed
In the last several years, bonds rated BBB—the lowest investment-grade classification on the scale of two of the three major bond-rating agencies—have surpassed higher-quality A-rated bonds in market value amid an increase in both supply and demand. Investors seeking to counter persistently low interest rates since the global financial crisis have been on the lookout for high-quality yield from issuers still rated as investment-grade.
Meanwhile, "a lot of corporations, given a low-growth environment and low financing costs, have been incentivised to lever up their balance sheets, primarily for shareholder-friendly activities such as buybacks, dividend payments and mergers and acquisitions," said Arvind Narayanan, Vanguard co-head of investment-grade credit. "It's that demand-and-supply dynamic that has allowed the market to grow."
BBB-rated bonds represent a growing part of the Bloomberg Barclays Global Aggregate Corporate Index
Source: Vanguard analysis of the Bloomberg Barclays Global Aggregate Corporate Index between May 30, 2008 and April 30, 2020. Bloomberg Barclays Global Aggregate Corporate Index used as proxy for global investment-grade corporate bond market. Past performance is not a reliable indicator of future results.
Growth in the BBB portion of the investment-grade market became a talking point even before the Covid-19 pandemic, given the increase in issuers that stood just a notch above high-yield status. The pandemic has only added to the concern as pressure on companies’ profit outlooks has risen amid widespread halts in economic activity. The energy industry in particular bears watching, given historically low oil prices recently, as do industries taking a direct hit from the pandemic.
The potential scope of downgrades
Vanguard estimates that as much as $400 billion worth of BBB bonds could be at risk of downgrade to high-yield in the United States as a result of the pandemic, depending on the path of economic recovery. That would mean about 6.5% of the $6.1 trillion US investment-grade corporate market and nearly 14% of the $2.9 trillion BBB market1.
"We would expect that downgrades would likely be of overleveraged companies in sectors that face severe sales slowdowns," Mr. Narayanan said. The sectors most directly affected by the pandemic—autos, leisure, hotels, restaurants, airlines and retail—account for 5.6% of the US investment-grade market.
By contrast, about $130 billion worth of BBB bonds were downgraded during the global financial crisis, or about 8% of the US investment-grade market at the time. The higher percentage compared with our estimates of potential fallen angels today reflects a wholesale downgrade of the banking sector during the financial crisis.
In Europe, Vanguard estimates that €30 billion ($32 billion) in BBB-minus debt with a negative outlook could be downgraded in the next three to six months, with potentially up to €200 billion ($216 billion) more at risk should a recession last longer than that.
The US investment-grade and BBB markets are about twice the size of their pan-European counterparts, including bonds in all European currencies, based on Bloomberg Barclays indices. This reflects that European companies have typically sought funding through bank loans, though they are increasingly turning to the bond markets.
The effect on indices and index funds
A downgrade to high-yield status leads affected securities to be excluded from an investment-grade index, and it requires index funds to divest them. But such downgrades rarely come as a surprise, and Vanguard index funds are well-positioned to take action on them.
"We do have to be sellers of those bonds," said Josh Barrickman, principal and co-head of Vanguard bond indexing for the Americas. "But we have quite a bit of leeway about how and when we exit those positions."
Vanguard’s deep and experienced credit research team works to identify companies whose fundamentals may be deteriorating. "If there’s a name where we have particular concern about a downgrade," Mr. Barrickman said, "we can start positioning in advance, underweighting the name or getting to a place where we’re holding the bonds we think will be most desirable to high-yield investors, or getting out of less-liquid bonds and into more-liquid bonds before the downgrade happens."
Such downgrades clearly aren’t positive events for index funds. "It does hurt performance generally as these go from Price A to Price B as they matriculate between investment-grade and high-yield indices," Mr. Barrickman said. As an index fund provider, Vanguard is "concerned about tracking, but we’re also concerned about getting the best possible price as we sell these securities. It’s a bit of a balancing act, perhaps half science and half art."
The role of central banks
The US high-yield market, valued at $1.2 trillion, is roughly a fifth of the size of the US investment-grade market. Although it should be in a position to absorb an influx of fallen angels, high volumes could test its ability to do so efficiently. Mr. Kulkarni likens it to pouring water from a bottle into a straw. Pour slowly enough and the straw can do the job. Pour too quickly and it is overrun. Central bank actions in April 2020 to support the corporate bond market in essence provided a wider straw, he said.
The US Federal Reserve, through its Primary Market Corporate Credit Facility and Secondary Market Corporate Credit Facility (SMCCF), is making up to $750 billion available to provide liquidity through the purchase of new and outstanding bonds of large employers. For the first time, the SMCCF allows the Fed to purchase fallen angels, provided they held investment-grade ratings as of 22 March 2020.
The European Central Bank similarly allows certain fallen angels to be eligible as collateral within its Eurosystem credit operations.
The active opportunity
The challenges of index fund methodology can present opportunities for both sophisticated index fund managers and, of course, active funds. "The forced selling that may occur as bonds migrate from one rating to another can potentially create valuations that deviate from fundamental value," said Michael Chang, Vanguard senior portfolio manager for high yield. "That creates the potential for opportunity for investors who don't necessarily have to manage toward certain rating thresholds."
The profile of fallen angels differs from that of traditional high-yield issuers. "They tend to be higher quality," Mr. Chang said. "In general, they tend to have greater scale, generate more cash flow and have greater financial flexibility. They tend to be the market leaders in their industries.
"So all else being equal in normal periods, fallen-angel issuers tend to compare very favourably with legacy high-yield companies in the same sector, and therefore, in normal times, investors tend to look upon fallen-angel issuers very favourably."
1 All market-size data is from Bloomberg Barclays indices as of April 30, 2020.
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