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.