Over US$150 billion of bonds have fallen from investment grade to speculative grade this year against the backdrop of COVID-19, wider market volatility and rising financial uncertainty. There have been more downgrades in the first four months of 2020 than in any prior full year. This growth in the number of fallen angels may not be over yet with almost $900 billion of investment grade bonds rated BBB-, just one notch above high-yield status, and more than $150 billion of investment-grade bonds already trading with a wider spread than BB-rated peers.
Despite their credit downgrades, fallen angels are a higher quality subset of high yield. They can offer investors a potentially attractive prospect as they tend to hold comparatively strong “BB” credit ratings, with about 85 per cent classed as “BB” grade investments. This means they are intrinsically less likely to default than many other high-yield assets.
No one could have predicted the COVID-19 pandemic would tip the balance for so many credit downgrades this year.
Looking forward we could see another US$200-400 billion of similar downgrades. This actually excites us for several reasons. What we have seen so far this year is more downgrades, more forced selling among index and institutional investors who through their various investment parameters are unable to hold high yield, and more discounts. This has ultimately led to higher returns and higher potential alpha for managers nimble enough to harness it.
Forced selling of investment grade bonds can create potential pockets of value, where supply-demand imbalances can mask the fair value of these bonds and where investment grade bonds can fall into the high-yield universe at a significant discount. The value for investors lies in recognizing that these bonds present a unique value proposition within the broader high-yield universe, which can be harvested by investing in a diversified manner to capture the structural alpha opportunity. However, cost and liquidity remain a formidable hurdle to achieving the full credit risk premium of fallen angel bonds. Average bid/ask spreads range between 70-90 basis points in normal market environments and magnitudes higher in stressed markets. This is an area we have been developing specialised implementation tools for since 2012.
Despite recent market turmoil, supportive action by the US Federal Reserve has also helped underpin market valuations. During the March market turmoil, the Fed came in and announced they were going to buy corporate debt, which was a very unusual move. A short while later it decided to extend this programme to buy, specifically, fallen angel bonds. This has provided a very supportive tailwind to the asset class in both the secondary and primary markets.
Some wonder if the latest surge in fallen angels – and the interest they have generated – is just a passing investment phase. We believe the market can offer significant long-term opportunities for committed investors – and this isn’t just a temporary opportunity. Fallen angels have asymmetrical return profiles as they tend to behave more like high-yield assets in “quiet” years with few downgrades.
However, in volatile markets you can see some significant outperformance among high-yield fallen angel bonds. This is where markets find themselves now and this trend will likely continue for some time and may present some attractive investment opportunities.
Paul Benson, head of fixed income efficient beta, Mellon