Market Views: Fixed Income
Fallen angels: why passive investors may face greater risks
The market is awash with BBB-rated corporate bonds. It has become an increasingly hot topic among financial commentators and for some a growing concern.
What are BBBs?
Bonds (whether issued by governments or companies) are assessed by ratings agencies and given a rating according to their level of risk. The top rating is AAA, then AA, then A, then BBB. These tiers are known as investment grade. Bonds rated below that level are known as high yield (or “junk”).
The share of BBB-rated bonds, the lowest tier of investment grade (IG) debt, as a proportion of the overall US market has reached an all-time high of 50%, compared to 33% in 2008.
Default rates (the proportion of companies missing a scheduled repayment on a bond or loan) on BBB-rated bonds have historically been low (0.2% a year, on average). A more pressing risk for investors is that the BBB area of the market starts to see credit rating downgrades. This has important implications for investors, as we explain below.
How a recession impacts corporate bonds
The possibility of an economic downturn has increased recently. Indeed, the Federal Reserve’s (Fed) probability model calculates the chance of a recession over the next 12 months to be 31.5%. This is higher than in July 2007. An economic downturn will likely result in companies’ sales, revenues, profits and ultimately earnings falling.
This will effectively reduce companies’ ability to cover interest payments on bonds and any other debt. Ultimately, this will make corporate bonds look riskier and, in all likelihood, have a negative impact on bond prices and valuations. Yields (interest income paid on bonds) and spreads (the difference in yields on corporate and lower risk government bonds) will rise and prices fall. Historically, this has also resulted in downgrades to company credit ratings.
Why downgrades matter
BBB-rated bonds are exposed to a particularly acute form of this downgrade risk. Because they are on the cusp of investment grade status, a downgrade would see them relegated to the high yield market. Such companies are known as “fallen angels”.
This is a problem as, for a variety of reasons, including regulation, many investors are only permitted to hold investment grade bonds and so would be forced to sell the downgraded bonds. Additionally, investors in passive funds (products which seek to directly track a market by replicating an index) would be forced to sell the bonds which drop out of the investment grade market indices. This potentially creates a cliff edge in pricing, whereby downward pressure on the “fallen angel” would be exacerbated by collective forced selling.
Then there is the issue of the timing of the sale. In the past, the point of downgrade has been the worst time to sell the bonds as prices will tend to fall in advance of the actual downgrade. Passive investors, however, would have to wait for the downgrade to occur and for the subsequent rebalancing of the index before selling. As such they would potentially be exposed to a significant amount of the price decline.
Given the current large size of the BBB segment, this risk is elevated. Fallen angel volumes could be higher than in previous credit cycles.
Why active beats passive
Adding to the risk is 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 2008.
Although the exact timing and volume of downgrades from the investment grade market is hard to predict, we can estimate their potential impact on investment grade index returns using historical experience. For example, based on Moody’s data covering 1920-2018, 3.2% of the investment grade market has been downgraded to high yield each year on average. If this happened today, $211 billion of bonds would be affected. However, downgrades are typically well above average during economic downturns and this figure could rise to between $275 billion and $557 billion, if the last three downturns are used as a guide. At the overall index level, this could result in a loss of up to 3.5%, or roughly $230 billion in monetary terms.
Whichever scenario occurs, the market is likely to move before the rating agencies act. Historically, most of the price decline has occurred ahead of the downgrade (as the chart below shows) with prices tending to partially recover in subsequent months. Selling at the point of downgrade would mean locking in close to the maximum potential loss.
Either the ability to sell before a downgrade or hold on to a fallen angel and sell later, 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 because they are not forced sellers and can also discriminate between what they deem to be healthy issuers and those they consider more vulnerable.
100bp = 1% (bp = basis point). Spread is the difference in yield between a corporate bond and one less risky, usually a government bond. Prices and spreads move inversely.
A credit rating is assigned by independent ratings agencies Standard & Poor’s, Moody’s and Fitch. A company is officially rated once it receives a minimum of two ratings. The overall rating will range from AAA, the highest, down to C, calculated as an average. A rating will reflect the agencies’ assessment of a company’s financials and overall strengths and weaknesses, particularly factors such as how much debt it owes, its ability to meet interest and debt repayments, level of profitability and whether it can be sustained, and so on.
 Moody’s Annual Default Study: Corporate Default and Recovery Rates, 1920-2018
 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.
 Morningstar Direct Fund Flows Commentary 2018 Global Report