Will (and When) Fallen Angels Grow Their Wings Back?
The dual shock of the negative economic effect of the COVID- 19 pandemic and the collapse in the oil markets has taken its toll on credit markets, leading to a spike in the number of fallen angels, or issuers downgraded to high-yield status from investment grade. Under such conditions, what are the kinds of risks and opportunities that would be assumed by investors who are either holding FA or would like to take advantage of the price dislocations that accompany such downgrades?
This year has witnessed more than US$131 billion worth of investment-grade (IG) bonds being downgraded to high-yield (HY) in the United States (US) and more than US$35 billion being downgraded in Europe, at a pace unseen in nearly two decades. The cumulative downgrades arising from these shocks are likely to exceed those experienced after the global financial crisis (GFC) by a wide margin. While recent actions by the US Federal Reserve (Fed) are supportive of credit markets in general and BBB- rated issuers in particular1 , the economic effects of the dual shock are deep and have the potential to affect both the affected sectors as well as credit markets broadly.
The nationally recognized statistical ratings organizations, most notably Moody’s, Standard & Poor’s and Fitch, are responsible for publishing independent assessments of the credit quality of bond issues, at the issuer’s expense. Their role in this current cycle is not to be underestimated: mass downgrades would rapidly raise the financing cost of credit-risky borrowers, which could further exacerbate the deterioration in credit markets.
With this background in mind, we seek to address the following investor concerns in relation to fallen angels (FA):
Magnitude of downgrade risks from FA in the US and European credit markets
Industries facing potential credit downgrades and resultant risks to indices
FA opportunities for risk-tolerant investors
HY market’s ability to absorb record FA volumes
Profile of HY indices after absorbing substantial FA volumes
Managing FA risk in credit portfolios
Magnitude of Downgrade Risks From FA in the US and European Credit Markets
The precipitous decline in oil prices and the shutdown of economic activity in response to the health crisis have resulted in a rapid reassessment of credit risks. Estimates of the size of this risk vary widely and range from a low of US$115 billion to a high of US$350 billion2 , including US$131 billion and US$35 billion worth of IG bonds that have already fallen to HY status in the US and European credit markets, respectively. While the rating response function is hard to fully replicate, we use the credit spreads in the market to assess the quantum of this risk as spreads are an integral part of the rating response function. Using credit spreads as a guide implies that we view the credit markets as being largely efficient in assessing the risks to cash flows, which impact the ratings.