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.
Our analysis of FA over the past 20 years indicates that approximately 84% of FA belong to the widest 10% option-adjusted spread (OAS) bucket, with most of them coming from the widest 5% OAS bucket. Using OAS and history as a guide for both the US and the European markets3 , we estimate that the upper limit of risk from FA is US$257 billion in the US and US$113 billion for euro IG (Figure 1).
Our credit team used a combination of quantitative and fundamental screens to estimate that the risk of downgrade for US IG market is in the range of US$250 billion–US$275 billion. To put this in context, during the GFC, the total worth of FA in US IG was US$200 billion and represented close to 10 % of the market. These projections are in the range of sell-side estimates and represent about 5% of the total notional amount outstanding in the US and euro IG indices.
Industries Facing Potential Credit Downgrades and Resultant Risks to Indices
The sectors that are likely to be affected could be identified from the aggregation of the candidates from our estimation approach outlined above. Oil shocks have resulted in significant distortions in the energy and basic industry sectors in the US. Similarly, the global shutdown of economic activity has had a negative effect on consumer cyclical and financial sectors. Sectors with the highest likely impact from our FA estimates in the Bloomberg Barclays US IG Corporate Bond Index are energy and finance companies with 18% and 41% of notional amount, respectively, likely to be downgraded to HY status. In the Bloomberg Barclays Euro IG Corporate Bond Index, consumer cyclical and insurance sectors are most at risk with 10% and 8% notional amounts, respectively, likely to be affected.
On the risk side of the equation, our FA candidates account for a non-trivial 5% and 8% of the index duration times spread4 (DTS, which is a measure of risk) in Bloomberg Barclays US IG Corporate and Euro IG Corporate Indices, respectively. Within each sector, this risk is clearly higher as the DTS contribution of our FA candidates account between 11% and 40% of the sector DTS in sectors that are heavily affected by the pandemic.
FA Opportunities for Risk-Tolerant Investors
An important issue that investors who are either holding FA in their portfolio or are considering ways to take advantage of price dislocations that accompany downgrades need to consider is the risk of permanent loss of capital. The price impact of a downgrade to an FA could be quite different depending on the beginning price (price on the day of downgrade)5.
To better assess the risk of permanent loss, we divided the universe of FA from 2003 to 2019 into four subgroups based on the beginning prices: the catastrophic risk group, which includes bonds priced below US$40; the distressed group for bonds priced between US$40 and US$70; the discounted group for bonds priced between US$70 and US$100; and the above-par group for bonds priced above par. We use US$40 as a price cut-off for classifying these bonds, as estimating recovery values for bonds priced below US$40 could prove to be very challenging. Distressed bonds priced between US$40 and US$70 can be great candidates for HY investors looking for value given: FA typically are of higher quality than average HY bonds and as a result there is a potential for market overreaction to default risks for the downgraded bonds.
Figure 2 shows the price movement of FA in these groups as well the groups combined. We use the 6-week pre-fall price as a benchmark for recovery. The data set contains all FA during the 17-year period of 2003-2019. We find that, on average, the catastrophic risk group never saw any meaningful price recovery within 26 weeks after a downgrade. Similarly, the above-par group suffered from a loss of premium and experienced a steady price decline without recouping the losses. As a result, these bonds suffered permanent loss of capital. Historically, these two groups have constituted about one third of the FA universe.
However, bonds in both the distressed group and the discounted group recovered their pre-fall price levels within 26 weeks after a downgrade. While not predictive, these historic outcomes provide holders of FA with a roadmap: favor holding/buying bonds falling in the distressed and discounted groups and selling those in the catastrophic and above-par groups.
HY Market’s Ability to Absorb Record FA Volumes
Our view is that both the US and the euro HY markets should be able to absorb the record-breaking volume of FA as long as the entire volume does not hit the markets all at once. Our reasons are as follows. First, during Q1 2020, we saw a significant repricing of risk as the spread – the difference between the OAS on BB-rated and BBB-rated bonds – widened from approximately 60 bp at year-end 2019 to 190 bp as of 31 May, reflecting the market’s expectation for both elevated credit risk and growth in the BB-rated category. While actual year-to-date FA volumes represent 46% and 28% of our upper limit projections for full-year 2020 FA in US and euro IG, respectively, we believe the repricing reflects market consensus for the full-year activity.
Secondly, and importantly, both the US and the euro HY markets have significantly increased in size since the GFC (from US$ 656 billion in September 2007 to US$1.27 trillion in March 2020 for US HY and from US$98 billion to US$329 billion for euro HY during the same period) and were able to accommodate relatively bigger names such as Ford. This means that the US and the euro HY markets were able to handle FA volumes equivalent to about 10% (US$119 billion of US$1.27 trillion and US$31 billion of US$329 billion) of the total market size in a relatively short timeframe of 3 months. Consequently, as long as the remaining FA volumes in our upper limit of US$130 billion (about 10% of US HY) and US$72 billion (about 25% of euro HY) do not hit the markets all at once, the US and the euro HY markets should be able to absorb the volumes without creating much friction.
Profile of HY Indices After Absorbing Substantial FA Volumes
To understand this better, we compared the characteristics of the HY index prior to the crisis-induced FA deluge with the current HY index to analyze whether our estimates would prove to be right. One could make the argument that since all of the FA are descendants of the IG index, they are likely to have relatively better quality.
As can be seen in Figure 3, inclusion of all the FA lowers the credit risk premium measured via spreads as well as yields. Furthermore, the average quality improves from B1 to BA3, but OAD is lengthened by about a third of a year. This is an expected outcome as FA are relatively higher-quality issuers within the HY index. With time, some of the FA do improve in quality and become rising stars. Historically, 18% of FA have managed to make their way back to IG status with an average time to return of 2.7 years. Most (75%) of the FA that turned back into IG did so in less than 3.7 years.
Since FA are of relatively higher quality than the average HY bond and a reasonable proportion of these do recover and become rising stars, is it prudent for investors to hold on to these bonds in their portfolios? Our answer is no, because significant tail risks exist within the group of FA bonds, and it is therefore important to consider a process to reduce these risks. In the next section, we propose a way forward to manage these risks and be selective in portfolio construction.
Managing FA Risk in Credit Portfolios
Our analysis suggests some guidelines to investors for portfolio action. Our research indicates that bonds that are either priced above par or are below US$40 at the time of a downgrade should be avoided in portfolios as they tend to suffer permanent losses. How about the bonds in the ‘distressed’ and ‘discounted’ groups? For IG investors with the flexibility to hold FA, we believe holding bonds that fall in the distressed and discounted groups could prove to be useful.
Figure 4 shows excess returns for both distressed and discounted groups. Both these groups show excess returns versus the US IG benchmark over the 26-week period subsequent to a downgrade, supporting a strategy of holding FA in these categories versus rushing to sell them. The same analysis holds true for HY investors, where the liquidity offered by large, formerly IG issuers falling into the universe creates opportunities to add exposure. Selection based on price can be a good indicator of value. Quantitative inputs can further narrow the focus of the selection by helping to identify and stay clear of “torpedoes”.
Figure 5 shows the results of the application of the estimates of probability of default from our quant and fundamental teams. Our probability of default (PD) estimates range from 0 to 1 with a higher number representing higher risk. By focusing on FA candidates with a PD number below 0.25, we may be able to significantly limit the tail risk implicit in these bonds6 . We show that limiting these candidates dramatically improves the return profile of this group. The minimum drops from -85% to -32% as does the volatility, improving the risk-adjusted return.
In summary, we assess the risk of downgrades to be significant in credit markets both in the US and Europe. Such risks are likely to be concentrated in sectors such as energy, basic industry, consumer cyclicals and insurance. Markets frequently overreact to the risk of defaults in these FA, which does not automatically imply that we should hold on to certain FA candidates unconditionally. However, our analysis does show that there are meaningful opportunities that emerge out of such overreactions. Thoughtful management of FA involves a careful calibration of all these elements, which has the potential to preserve and add returns in a market segment that is expected to significantly expand over the next year.
1The Fed announced the establishment of the Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF) on 23 March 2020. On 9 April 2020, the Fed announced that it will buy bonds that were IG rated as of 2 March 2020 and subsequently downgraded the requirement to no lower than BB-.
2 “Virus Sell-Off Turns Bonds Into ‘Fallen Angels.’ Here’s Why Downgrades Matter”, Bloomberg, April 2020.
3To assess an upper limit of the downgrade risk in IG markets today, we project that all of the bonds in the widest 5% OAS bucket and a portion of the ones in the 5%-10% bucket are vulnerable to downgrade risks. In estimating the proportion for the 5%-10% bucket, we use history as a guide and apply comparable percentages (86%:14% for US IG and 82%:18% for euro IG).
4DTS is the market standard method for measuring the credit volatility of a corporate bond. It is calculated by simply multiplying two readily available bond characteristics: the spread-durations and the credit spread.
5This notion again relies on some level of market efficiency of credit markets in assessing solvency risk.
6Bonds with probability of default below 0.25 account for 98% of all FA included in the analysis.
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