As companies keep on addressing pandemic issues, rating agencies such as Moody’s, Fitch and Standard and Poor’s are busy downgrading bond issuers at a record pace. JPMorgan estimates that more than $215 billion in the US and €100 billion in euro corporate bonds will be downgraded from investment grade to high- yield status any time during 2020.
On a dollar basis, recent fallen angel activity has already surpassed the prior record in 2009 of over $140 billion, including sizeable issuers such as Ford Motor Co., Lufthansa, Kraft Heinz and Occidental Petroleum. However, one must add that currently the IGB (Investment Grade Bond) market is remarkably different in size and composition than it was in 2009, with 50 per cent of the bonds rated at BBB, as opposed to prior to the crisis, when BBB rated bonds amounted to 39 per cent of IGB’s. Moreover, on a euro basis, the BBB market is almost six times greater than it was in 2009.
A fallen angel, which is a bond that was rated investment grade but has since been downgraded to junk status, is synonymous with bond issuers experiencing rising debt levels on the back of declining revenues. This scenario is even exacerbated in a period of an economic slowdown like the one we are experiencing now.
Although the downgrade may be viewed as a negative, fallen angels are attractive in three different scenarios: i) long-term contrarian investors who want to capitalise on the entity’s ability to recover, ii) portfolios which have a high-yield allocation in their mandate by opting to buy higher quality bonds than the average high-yield bonds, as they have the potential of bouncing back to investment grade; and iii) short- term traders who take advantage of supply pressure by investment grade funds obliged to sell their holdings due to a mandate breach.
Despite government and central banks’ interventions, it will be difficult to safeguard all companies from default
Most of the companies work hard to regain Investment Grade status as it lowers their cost of capital, i.e. lower yield, in case they need refinancing and it will be easier for them to get access to injections both from the credit market and from the banks.
Funds targeting fallen angels bonds were boosted recently, following the Federal Reserve’s comments that it will expand the scope of the bond-buying programme to include a limited amount of recently downgraded high-yield debt. The Fed’s commitment not only helped to ease fears in the market but gave investors a lot of comfort and this showed in their respective performance. This followed a selling spree by investors which exacerbated a strain in corporate bond markets. It is now very common to find a BBB-rated bonds trading with yields comparable to BB rated bonds.
Maintaining a strong balance sheet and holding investment grade credit rating is key for these companies to keep their capital expenditure and interest payments at a low, but it will surely be difficult for companies operating in the energy, automobile, airlines, gambling, retail and hospitality to recover any time soon from this pandemic.
Despite government and central banks’ interventions, it will be difficult to safeguard all companies from default, especially those hardly hit by the pandemic, as happened with Whiting Petroleum, a US shale oil producer, and J. Crew, the first victim from the retail space, which filed for bankruptcy last month.
Despite the obvious concerns, a rise in fallen angel activity provides opportunities to investors who are able to navigate through this market. Given the weakening credit market, spreads have started to reflect downgrade risk, thus providing potentially attractive entry points to add exposure prior to the downgrade event. Recently downgraded issuers experienced a price hit prior to entering the high-yield market and thus offering a good entry point for companies which will end up recovering and provide a good long-term, total return potential.
This article is not, and nothing in it should be construed as an offer, invitation or recommendation in respect of investment products or services offered by the BOV Group.
Clifton Caruana, Portfolio manager at BOV Wealth Management