Even in good times, it’s not unusual for companies clinging to the bottom rung of the investment-grade ladder to become fallen angels. Yet concerns surrounding fallen angels are especially pronounced today, and not just because of the coronavirus pandemic and concurrent oil crash. During the past decade, the volume of debt rated BBB—the lowest rank of investment grade—ballooned as a share of the investment-grade universe as issuers ramped up their leverage.
Given the sudden onset of liquidity challenges and reduced access to capital in today’s environment, we estimate that 8.5% of the US investment-grade corporate market will be downgraded below investment grade. This is close to the experiences in past crises, such as the 2002 recession (10%) and the Great Recession (8%). However, because today’s investment-grade corporate market is four times as large as in 2008, our US fallen angel forecast is for around $450 billion by volume. The actual figure so far in 2020 has already surpassed $150 billion.
The potential for a blizzard of fallen angels to overwhelm the high-yield market has exerted downward pressure on both bonds rated BBB– and the highest-rated high-yield bonds. A wave of downgrades from investment grade to high yield could lock in losses for restricted investment-grade strategies and spark a disruptive repricing in the high-yield market as it digests a supersized volume of incoming debt.
But for investors who can hold them, 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 performing very well. This has held true even following a sizable surge in volume. The Great Recession, for example, saw a big increase in the volume of fallen angels; in 2009, total returns on fallen angels surpassed 60%.
For high-yield investors, that’s an opportunity worth exploring.
