In a religious context, ‘a fallen angel’ refers to an angel expelled from heaven, one who has chosen to give up the righteous path for a life of sin. Similarly, in the global bond market, fallen angel is a term used for borrowers who once held coveted investment grade credit ratings, but who have now been downgraded to high yield status (i.e. carrying risk) based on the credit worthiness.
The global bond market is segregated by credit ratings. These credit ratings, issued by credit rating agencies and variable through time, are an assessment of a bond issuer’s creditworthiness: an evaluation of their ability to service the debt and their probability of default are therefore critical to determining the terms at which a company can borrow. Much like a personal credit score determines how much you may be able to borrow for a mortgage, company credit ratings help investors understand the risk of companies borrowing in the bond markets.
Investors globally segregate credit ratings for bonds into two tiers – ‘investment grade’, those issuers deemed to have credit rating in the top tiers of the spectrum and where default risk is low, and ‘high yield’, those issuers with lower credit ratings and therefore a higher probability of default.
This segregation is a critical dynamic to understand, because many investors treat each market segment as a separate silo. This means that when a bond moves between the two segments – either because it has been downgraded or upgraded – investors may need to remove or add the bond to their portfolios depending on the direction of travel and the silo of focus.
The coronavirus pandemic and associated decline in oil prices witnessed earlier this year, has created a surge in credit rating downgrades in the bond market, meaning more companies have dropped into the lower tiers. So far this year around 30bn worth of US corporate bonds have been downgraded to fallen angel status1, with many estimates suggesting many more bonds will follow. That compares to an average of 2bn per annum between 2009 and 2018.
Ordinarily this is not a good thing – the credit worthiness of borrowers at an aggregate level is an important bellwether for the wider health of corporate balance sheets. Those companies downgraded will now find it harder to raise new capital and will have to pay higher returns to investors in order to access funding, potentially weakening their position at an already challenging time.
However, the unique nature of the current crisis, investors typical anticipation of these downgrades, the support mechanisms employed from policy makers, and the signs of an emerging economic recovery offer a counterbalance to that negative picture.
The long road to high yield status
So how is it possible that so many companies have faced downgrades to high yield status in such a short period? Well the truth is that recent events have simply been the straw that has broken the camel’s back when it comes to companies losing their investment grade ratings.
The percentage of BBB rated corporate bonds, the lowest tier permissible in the investment grade segment of the bond market, has been increasing for some time as investment grade companies credit worthiness has declined. In fact, the percentage of bonds holding the BBB credit rating increased from 17% in 2001 to over 50% at the end of 2019, according to Barclays. A whole range of factors have contributed to this decline over the past decade. They have been broadly enabled by the historically lower cost of borrowing which has encouraged companies to increase their debt burdens despite a relatively low growth environment.
So, 50% of the investment grade universe has been teetering on the edge of high yield (high risk) territory for some time, but the pandemic, and its immediate effects on company profitability and wider economic activity, has brought this dynamic sharply into focus in 2020. The effects of the temporary shutdown of economies have been felt across economic sectors, some more keenly than others but the impact on corporate profitability is widespread, and therefore so is the impact on declining creditworthiness.
This is most evident in the energy industry, where a notable decline in the price of crude oil has significantly impacted the profitability of many operations. As such, the percentage of energy companies included in the fallen angel segment almost doubled from March to June this year – increasing from just under 12% to just over 20%3.
But it’s also important to recognise that this is a first step into high yield territory for many companies rather than a signal of impending default. Typically, issuers in fallen angel territory will compare very favourably against existing high yield issuers from a financial health perspective, especially when it comes to their ability to generate cash flow, their size, and their positions of leadership in industry. Recent additions to the fallen angel universe certainly fit this profile: companies like Ford, Heinz, and Marks & Spencer have all lost their investment grade rating so far this year.
In fact, the proliferation of companies losing their investment grade status looks set to change the shape of the overall high yield market, increasing the credit quality as more issuers join the top ranks of high yield debt. It will also extend the maturity of the high yield debt market given investors have typically been willing to lend for longer to investment grade companies – meaning the remaining time to maturity of fallen angels’ bonds is longer than that of the typical high yield company.
Why are fallen angels attractive to us?
In recent months, we’ve been adding to holdings in fallen angels in Nutmeg portfolios. We believe fallen angels have several attractions relative to traditional high yield bonds at the current time.
First, fallen angels have historically provided investors with a better risk reward trade-off. That is, although volatility has actually been higher in fallen angels over the longer term, the greater rewards on offer from fallen angels more than makes up for this, making the asset class more attractive from a long term risk reward perspective than typical high yield bonds.
Historically, while fallen angels have a better credit rating profile, this segment of the market has tended to come with more concentration risk – that is that there are fewer borrowers and thus more company specific or industry specific risk. However, as previously discussed, the current environment has led to a proliferation of companies across sectors moving to fallen angel status, meaning a more diversified exposure to the asset class is available. In our portfolios, we also use an ETF that caps exposure to any given company at 3% – ensuring company specific risk is limited.
And while the number of companies being downgraded has rapidly grown, we’ve also witnessed a shift in central bank policy in the US and Europe that has provided important support for the fallen angel segment of the market. In the US, the Federal Reserve has extended a safety net by agreeing to purchase fallen angels as part of its corporate bond buying program, improving liquidity and ensuring companies can access funding. Separately, the European Central Bank – which has purchased corporate bonds to support the market since 2016 – has recently also relaxed its rating requirements on collateral to include fallen angels – and may yet seek to mirror the Federal Reserve and commit to outright purchases.
Source: Nutmeg, Bloomberg August 2020
Meanwhile, we think the unique dynamics of the asset class offer an interesting opportunity for investors. There are several studies that identify how the shift from investment grade to high yield status can cause temporary price dislocations for fallen angel bonds, and therefore an opportunity for longer term investors. When bonds lose their investment grade status, investment grade only focused investors are forced to sell their holdings in these bonds, often depressing prices as a result. However, the evidence shows fallen angels tend to recover their values in the period immediately after downgrade, as high yield focused investors add the securities to their portfolios.
Finally, the fallen angel universe remains significantly higher credit quality than the high yield universe – although these companies have lost their investment grade status, they typically remain in the top tiers of the high yield universe from a credit rating perspective. And that offers them the potential to regain that investment grade status should their creditworthiness improve – which an enduring economic recovery should offer some companies the opportunity to do so.
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