How serious is the risk from the impending spike in "fallen angels"?

The risk that the large increase in BBB corporate bonds will result in a wave of “fallen angels”, bonds being downgraded from investment grade (IG) to high yield (HY), has been talked about for some time now. With the coronavirus outbreak and plummeting oil prices putting the global economy on a path to recession it is becoming a reality.

It remains to be seen how pronounced the downgrade cycle becomes, but a number of US companies have already been stripped of their IG ratings. This has included household names such as carmaker Ford and department store chain Macy’s, and others such as energy company Occidental Petroleum.

Why the risk?

Since the 2008 Global Financial Crisis (GFC), rating agencies have given corporates significant leeway to operate with higher debt levels because borrowing costs have been low and profit growth has been strong. However, a steep decline in earnings could increase leverage and decrease cash available to cover interest payments, triggering a slew of cuts to credit ratings.

BBB-rated bonds are most vulnerable in this scenario because they are on the cusp of IG debt so a downgrade would see them relegated to the HY market.

For a variety of reasons, many investors will only invest in bonds with an IG rating. For some, regulation is the driving force. For others, it is down to the way certain strategies have been designed. For example, a passive strategy investing in IG bonds will only hold bonds that are part of the IG market they are designed to track. As a result, these kinds of funds are forced to sell a bond which loses IG status. With numerous funds having to sell at the same time, this would create significant selling pressure in the market, potentially exacerbating downward moves in the price of fallen angels.

Downgrades from IG have the potential to have a much bigger market impact than in the past, as the share of the US IG market that is rated BBB has swelled to 47%, compared with 33% in 2008. Index providers have taken notice of this risk and have even gone as far as to postpone their month-end rebalancing to soften the blow.

Investors who are able would be wise to avoid participating in the wave of forced selling. A more astute strategy would be to hold, or even buy, issuers that are likely to recover following the downgrade.

How have credit markets responded so far?

Investors have moved swiftly ahead of rating agencies in pricing in potential downgrades. As at 27 March, the average credit spread on US BB debt, the top tier of HY debt, was around 660 basis points. But about $347 billion of BBB debt traded at a higher spread than that, representing 10% of total outstanding BBB debt.

What’s more, close to $868 billion of BBB debt, or 26% of the total, traded at a spread greater than 450 basis points – a level typical of HY debt under normal market conditions (see chart).

Source: ICE, Schroders. Data as at 27 March 2020. Notes: US BBB = ICE BofA BBB US Corporate Index, US BB = US BBB = ICE BofA BB US High Yield Index.

It is important to highlight that not all of these issuers will get downgraded. Market moves in the wake of the Covid-19 pandemic have been extreme, solid companies with higher quality ratings than BBB are being sold off and some bonds will have very likely have become mispriced.

The sharp rise in spreads across credit markets is partly related to the deterioration in liquidity conditions and seems to have been more severe as a consequence. This means investors need to be choosy about which issuers look most vulnerable and those that are likely to weather the storm.

What impact could fallen angels have on the IG market?

Although the exact timing and volume of downgrades from the IG market is hard to predict, we can estimate their potential impact on IG index returns using historical experience. For example, if the last three US recessions are used as a guide, between $277 to $561 billion of BBB debt could be downgraded, with losses at the index level between -1.2% to -4.1%. These results are summarised in the table below.

Forecasts included should not be relied upon and are not guaranteed.
Source: ICE, Bloomberg, JP Morgan, Schroders. Spread data as at 6^th March 2020. Notes: US BBB = ICE BofA BBB US Corporate Index, US BB = US BBB = ICE BofA BB US High Yield Index.

However, this does not adjust for the significantly higher proportion of BBB-rated debt today compared to the past. On top of that, Schroders’ economics team expects the global recession to be the worst since the Great Depression of the late 1930's. As a result, these projections may understate the potential losses that investors could be exposed to.

Investors should embrace a flexible approach

Whichever scenario takes place, selling downgraded bonds when they exit their respective IG bond index tends to be the worst time to do so as it coincides with when credit spreads peak and bond prices trough, resulting in the highest crystallised loss. This is illustrated in the next chart.

Past performance is not a guide to future performance and may not be repeated. Source: Morgan Stanley Research. Median spread widening of fallen angels as at 5 October 2018.

Yet prices typically rebound somewhat after a period of forced selling has ended. As well as being related to an overshoot in prices, this also has a fundamental underpinning as many fallen angels will attempt to repair their balance sheet to regain IG status. This means any flexibility to hold on to, or buy fallen angels could potentially result in a better outcome. This approach has yielded above-average market returns without an undue increase in risk (see chart).

Past performance is not a guide to future performance and may not be repeated. Source: ICE, Schroders. Data from 1^st January 1997 to 28^th February 2020. Notes: US IG = ICE BofA US Corporate Index, US fallen angels = ICE BofA BB US Fallen Angels High Yield Index.

Not all fallen angel bonds are equal so a selective approach is key. For example, the transport, hospitality and retail sectors are most exposed to the current recession given their sensitivity to travel restrictions and consumer demand.

The energy sector is also under immense strain given tanking oil prices. Meanwhile, the more defensive areas of the market such as consumer staples, utilities, healthcare and telecoms may be better able to withstand the economic disruption.

Fund managers with the flexibility to discriminate between healthy and vulnerable issuers have the best chances of mitigating losses and could even benefit from this downgrade cycle. However, history would indicate passive investors and other strategies which must sell around the point of a downgrade are inherently disadvantaged in this environment.