The downgrade risks facing passive investment grade bondholders
Passive credit investors could be facing significant downgrade losses when the next economic downturn hits. Active managers, however, have the flexibility to manage these risks more efficiently.
Investors are increasingly worried about the growing size of the BBB-rated corporate bond market, the lowest tier of investment grade (IG) debt. The risk is that much of this segment could be downgraded to high yield (HY) when the next economic downturn occurs.
Passive investors would be the most exposed because they would have to sell these “fallen angels” when they exit their respective IG bond index. Although not all active managers will outperform, the risks of passive investing are greater now than they have ever been.
Passive investors risk holding "fallen angels"
BBB-rated bonds are exposed to a particularly acute form of this risk. Because they are on the cusp of IG status, a downgrade would see them relegated to the high yield (HY) market (these are known as fallen angels). This is a problem as, for a variety of reasons, including regulation, many investors are only permitted to hold IG bonds and so would be forced to sell the downgraded bonds.
Additionally, all passive investors would be forced to sell these bonds because they would exit all IG market indices at the next rebalancing date (usually the following month)¹. This market segmentation results in a cliff edge in pricing, hanging on whether a bond maintains or loses its IG status. Unfortunately for these investors, the point of downgrade has historically been the worst possible time to sell these bonds.
Given the current large size of the BBB segment, this risk is especially elevated. Fallen angel volumes could be higher than in previous credit cycles and this could weaken portfolio returns. Passive strategies are particularly exposed to this risk, not least because of the sheer increase in passive bond products. Around 28% of all US bond assets under management are now owned by passive index funds, up from 9% in 2008².
Being flexible can mitigate against downgrade losses
Whichever scenario occurs, the market is likely to move before the rating agencies act.
Historically, spreads of fallen angels have widened by around 300 basis points, or 3%, ahead of a downgrade to HY. Although they have continued to rise by around another 50 basis points, on average, in the immediate aftermath, most of the pain has already been felt.
In addition, prices tend to partially recover in the months that follow. Selling at the point of downgrade would have been suboptimal, locking in close to the maximum potential loss. Either the ability to sell before a downgrade or hold onto a fallen angel and sell later on, would have generated a better outcome. Neither option is fully open to passive investors. In contrast, active managers have the flexibility to manage fallen angel risk more efficiently because they are not forced sellers and can also discriminate between healthy issuers and those that are more vulnerable.
¹ Most passive investors trade throughout the month as opposed to rebalancing on a single day at month end. This means that they can technically sell bonds before/after a downgrade. However, doing so would increase the tracking error of the index fund so there is an inherent trade-off between tracking the performance of an index and avoiding bonds that may harm the fund’s performance. Seeing as the objective of a passive fund is to track an index, passive investors have very limited, if any, flexibility to manage fallen angel risk.
² Morningstar Direct Fund Flows Commentary 2018 Global Report
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