In the past, the high-yield market has reliably absorbed large volumes of fallen angels. Nonetheless, the potential for a blizzard of fallen angels to overwhelm the high-yield market in terms of both comparative volume and difference in average market duration (interest-rate sensitivity) has exerted enormous pressure on both bonds rated BBB– and the highest-rated high-yield bonds.
Thankfully, with the US Federal Reserve now prepared to buy some fallen angel debt and provide liquidity to eligible fallen angels, that pressure will be reduced. We estimate that US$34.5 billion of fallen angel debt will be eligible for purchase under the Fed’s Secondary Market Corporate Credit Facility (SMCCF).
While this should help soften the impact, it doesn’t reduce our forecast for fallen angels in the coming months.
Some Industries Will Be Spared
Industries most at risk for fallen angels are those directly impacted by the coronavirus pandemic, those along the global supply chain and those hurt by lower energy prices.
The lion’s share of fallen angels will be issuers from industries directly affected by the coronavirus crisis. These include consumer cyclicals, such as autos, gaming, leisure, airlines, homebuilders and retailers. These industries are suffering from prolonged stay-home orders that have dried up discretionary spending and large purchases.
Also at risk are issuers that came into the crisis highly leveraged in their ramp-up to mergers and acquisitions. These are primarily food and beverage companies. Reeling from empty restaurants and disruptions in the food supply chain, this sector faces a tough road ahead.
And energy issuers are under extra pressure, thanks to the oil shock. Although we expect oil prices to recover over time, today’s ultralow prices create huge challenges for many energy companies.
In contrast to the industries above, financials and utilities may be less vulnerable to fallen angel risk. Combined, these represent just one percentage point of our 8.5% projection for US fallen angels.
While earnings leave some room for improvement, large banks’ balance sheets were in relatively solid financial shape coming into the crisis, unlike in 2008. And utility providers’ revenue flows should hold steady, but with a noticeable shift from commercial to residential consumption for the near term.
That said, fundamentals in the financial and utility sectors may also deteriorate as the crisis continues and uncertainty remains elevated. It’s therefore important to be selective and watchful, in addition to paying attention to position in the capital structure.
It’s Time to Lean—Cautiously—into Risk
Investors who are able to ride out near-term volatility might consider increasing their credit exposure now. With spreads still exceptionally wide by historical measures, we see opportunities in both investment-grade and high-yield markets. It’s critical, though, to be discriminating.
Our research not only identifies those investment-grade bonds that are likely to become fallen angels, but also assigns internal ratings to issuers. These can then be compared to a security’s market price. Securities that are priced as less risky than our research indicates may warrant caution, whereas credits that the market is pricing as riskier than our research suggests may be attractive opportunities.
This kind of scrutiny is important for all types of investors.
For managers who are prohibited from owning high-yield bonds, avoiding the riskiest BBBs in today’s market should be a top priority. Since these investors must sell any high-yield credits, they’ll be better off unloading the vulnerable securities before the rating agencies act.
For investors who can hold high-yield debt, owning some angels after they’ve fallen may make sense. This is because fallen angels tend to enter the high-yield universe undervalued relative to their credit fundamentals and often end up outperforming original-issue high-yield bonds. In addition, the Fed’s SMCCF provides more than the usual support for fallen angels. High-yield investors should also consider BB and B issuers with strong liquidity profiles, which help manage pricing pressure in sharp sell-offs.
Above all, it’s important not to overreact to swings in investor sentiment. Avoiding the credit market entirely for fear of downgrades and defaults is just as risky as indiscriminately increasing exposure to corporates now that spreads are wider. In our view, careful analysis is essential for uncovering value and raising overall return potential, no matter the state of the market.
