- Rapidly declining economic activity and deteriorating fundamentals have led to over $100 billion in downgrades from investment grade to high yield year to date.
- Fallen angel activity on a dollar basis will likely reach record levels given the size of the BBB market coming into this crisis.
- Issuers within the energy, automotive, transportation, retail and lodging sectors pose the greatest downgrade risk.
- The Fed's corporate credit facilities may help instill confidence and promote effective market transitioning within crossover credit, thus potentially cushioning price declines.
- Fallen angels can result in market dislocations given potentially distorted technicals, but may also present opportunities for managers that can effectively navigate the crossover credit space.
How has the coronavirus crisis affected corporate credit ratings?
After relatively benign fallen angel activity in recent years, corporate debt downgrades are now front and center. Against a backdrop of extremely volatile economic activity, the ability of issuers to maintain their investment grade (IG) status is being challenged given evaporating revenue streams, plummeting oil prices, shattered supply chains and potential earnings disruptions.
After being scrutinized for slow reaction times during the last crisis, rating agencies are downgrading credits at a record pace. In March alone, approximately $90 billion of bonds were downgraded from investment grade to high yield status, bringing the 2020 year-to-date total to $150.4 billion (Exhibit 1). On a dollar basis, recent fallen angel activity has surpassed the prior record in 2009 of $141.4 billion. The downgrades included sizable issuers such as Ford Motor Co and Occidental Petroleum Corp, comprising over $62 billion, which will inevitably become some of the largest issuers in the high yield index when it rebalances.
While the economic and public health situation is changing rapidly, at this point, we expect a material increase in fallen angel activity during 2020.
Exhibit 1: US Fallen Angels
Source: JP Morgan as of April 14, 2020.
What's your estimate on the magnitude of fallen angel activity?
Many sell-side research firms estimate fallen angel activity in 2020 to range anywhere from about $115 billion to $350 billion. While many uncertainties remain, downgrades from investment grade to high yield could be on the upper end of that range.
Looking at historical data from Moody's between 1970 and 2018, the top ten largest fallen angel years experienced an average downgrade rate of 11% (Exhibit 2). Notably, fallen angel activity from the last financial crisis doesn't even make the top ten list with approximately 5% and 6.5% of downgrades from investment grade to high yield in 2008 and 2009, respectively.
Applying the 11% average to the current BBB market value of $2.99 trillion as of February 2020 could result in $330 billion of fallen angel activity. On a percentage basis, fallen angel activity may be in line with historical averages, but on a dollar basis, this crisis is resulting in the largest fallen angel activity in history given the sheer amount of outstanding BBB debt coming into 2020.
Exhibit 2: Top 10 largest historical fallen angel years
|Year||Fallen Angel %|
Source: Aegon AM US and Moody's. Reflects top 10 largest annual ratings transition years from BBB to high yield ratings based on data from Moody's from 1970 – 2018.
How do you expect this downgrade cycle to compare to prior crises?
The current BBB market is remarkably different in size and industry composition relative to prior crises. The BBB market comprises approximately $2.99 trillion, or 50% of the $6 trillion investment grade market as of February 2020. For reference, prior to the global financial crisis, only 39% of investment grade bonds were rated BBB.
Further, what once was a ratings segment biased towards cyclical companies, the current BBB market coming into the crisis consisted of a host of large cap credits in noncyclical sectors as well. As a result, unlike prior crises, the fallen angel activity in the coronavirus crisis will likely include a more diverse group of industries. While most industries will be impacted by the coronavirus crisis, we expect downgrades from investment grade to high yield to be concentrated within the energy, automotive, transportation, retail and lodging sectors.
What could this mean for the investment grade market?
Typically fallen angels lead to a dislocated technical environment in the investment grade market. It is no secret that the transition from investment grade to high yield is inefficient, primarily due to the sheer size difference of the two markets. Thinking about this in terms of a funnel, fallen angels get stuck in the top of the funnel, or the investment grade market, waiting for bids to develop from the bottom of the funnel, or the high yield market. When forced sellers appear, in order for them to get through the funnel in a timely manner, they need to accept a much lower price than fundamentals may dictate. This typically leads to oversold valuations for fallen angels.
Downgrade contagion usually spreads to other parts of the investment grade bond market as other credits are often compared to the valuations of these new fallen angels, which can negatively affect valuations of the entire sector. Ultimately, after this process concludes and oversold fallen angels start trading on fundamentals once again, the investment grade market will likely be left in a better place, with weaker names having moved to the high yield market.
However, the current environment is unlike prior crises. The Federal Reserve's recent commitment to support investment grade credit as well as fallen angels may limit the price declines for companies transitioning from investment grade to high yield. In an effort to balance supply and demand functions and restore confidence, the Fed may support financing and the secondary trading of recent and future fallen angels through the Primary and Secondary Market Corporate Credit Facilities (PMCCF and SMCCF). In practice, the facility's impact is yet to be seen, but in theory it is already working as recent fallen angels and potential cross-under candidates have seen very strong price performance since last week's announcement.
How will this affect the high yield market?
If fallen angels amount to $330 billion, it will equate to approximately 25% of the $1.3 trillion high yield market based on data as of February 2020. If downgrades materialize at this pace, the high yield market may have increased difficulty absorbing the rising number of fallen angels. Although the high yield market has been able to absorb over $100 billion of fallen angels year to date, it has come at a cost to those issuers. Typically, the 2020 fallen angels have decreased in price by 10-70 points over the course of the transition, depending on the issuer and maturity of the bonds. Unfortunately, the ratings migration is coming at a time when default expectations are rising for large number of companies tied to the energy, transportation and consumer discretionary sectors.
Additional challenges for high yield managers that can arise during periods of increased rating migration may include; managing issuer concentration limits caused by the size of some investment grade issuers, increased interest rate risk given the longer duration of many BBB bonds, and reduced covenant packages relative to traditional high yield issuance. From an investment grade manager perspective, the urgency with which they want, or need, to address the downgrade is also a major contributor. The more discretion a manager has in addressing the downgrades can provide them an opportunity to avoid a forced fire-sale of assets. There seems to be some flexibility with IG managers in holding high yield issuers compared to past downgrade cycles, although this could be tested if fallen angel volumes balloon above $200 billion.
Does fallen angel risk translate into opportunity?
Despite the headline concerns, a rise in fallen angel activity also provides opportunities to active investment managers who are able to effectively navigate the crossover credit market.
Given the weakening credit market, spreads have started to reflect downgrade risk, thus providing potentially attractive entry points for high yield managers to add exposure prior to the downgrade event. Many of the fallen angels in 2020 have experienced a price decline of 10-70 points with the "hit" taken prior to entering the high yield index. To the extent these companies end up recovering, they could present good long term, total return potential. The influx of fallen angels also creates a more diverse index with some of the larger industry credits. Some of the 2020 fallen angel industry leaders include Kraft Heinz, Ford, Macy's and Occidental Petroleum. While the verdict is still out on their recovery, most of these issuers yield over 8% presenting a potentially attractive buying opportunity provided the long-term fundamental outlook is solid.
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