The coronavirus pandemic and low oil prices have led to a surge in ‘fallen angels’, companies downgraded from investment grade to sub-investment grade. Ford, Kraft Heinz, Renault and Marks & Spencer are amongst the issuers that have become fallen angels so far this year.
We often see price falls in such downgraded bonds. Investment grade (IG) and high yield (HY) are typically treated as separate silos in an investor’s portfolios, which can lead to significant turnover of bonds from IG portfolios to HY portfolios when an issuer is junked. Figure 1 below shows the price action of three recent fallen angels with Ford, which has the largest debt pile, falling the furthest. We can also see that the market often anticipates the rating action before the agencies act.
The relative size of the IG and HY markets, as shown in Figure 2 below, intensifies the price moves. BBBs now account for just under half of the euro IG market and is over four times the size of the European HY market. This isn’t a European phenomenon: US BBB accounts for 48% of the IG market, and the BBB market is over three times the size of the US HY market. This exacerbates the price movements as supply exceeds demand.
The growth of BBB rated debt has been well documented, but, until this crisis, most commentators were sanguine about the risk of heightened fallen angels (Figure 3 below). The rating agencies also seemed to give company managements the benefit of the doubt when they made debt-finance acquisitions.
But the crisis has spurred the agencies into action. S&P, for instance, has taken negative rating actions on 383 IG rated issuers affected by COVID-19 and oil to April 17th 20201. They have junked 23 issuers so far this year2.
There is huge potential for more fallen angels. There is €243bn of BBB- rated debt in the IG index, of which €107bn is either on rating watch negative or bears a negative outlook. The fallen angel rate of BBB issuers hit 12.88% in 19863 and a similar rate would see €156bn of euro fallen angels and $457bn in the US market. Goldman Sachs forecast €180bn of fallen angels in the euro market over the next two quarters4.
So we see a surge of fallen angels and expect their prices to fall due to the relative size of the IG and HY market. Is there any good news?
Fortunately, the answer is yes. When we look at Figure 4, which shows the performance of fallen angels versus other HY (called ‘original issue HY’) and IG, we see that fallen angels have outperformed over the long term.
The fallen angel index isn’t for the faint hearted – the size of the market waxes and wanes and will sometimes be highly concentrated. Volatility is higher than that of HY. But the long term performance is compelling as the higher returns compensate for the higher volatility. In fact, as shown in Figure 5 below, fallen angels have only underperformed original issue HY over a rolling three-year period in 10 out of the last 232 months.
How can this outperformance be explained? It is because the prices fall initially making them cheap, and over the longer term the survivors are more likely to return to IG as a ‘rising star’ than original HY issuer.
The churn of bonds from the IG to HY market causes prices to fall, and this is exacerbated not only by the relative size of the markets, but also because IG issuers often have much longer dated bonds that are more sensitive to spread widening.
Fallen angels are both more likely to default and return to investment grade than original issue HY5. Initially, the risk of a fallen angel defaulting is actually higher than original issue HY. Fraudulent companies default soon after downgrade to sub-investment grade. Enron defaulted six days after being junked. However, after a year or so, a fallen angel has a higher chance of becoming a rising star and return to investment grade. This is because fallen angels have several of the characteristics, such as size and industry type, required to for an IG rating that other HY issuers lack.
We expect this current episode lead to a surge in fallen angels. This will lead to mark to market volatility in the short term as IG holders sell to HY investors. The lesson from history is that the bonds of survivors achieve outsized returns.
3 Annual default study: Defaults will edge higher in 2020, Moody’s, 30 January 2020
4 The Credit Line: The two sides of “fallen-angel” downgrades: Risk vs. risk premium, Goldman Sachs, 20 April 2020
5 What Happens To Fallen Angels? A Statistical Review 1982—2003, Moody’s, July 2003