Fallen Angels: Bond Downgrades Ahead?

Fallen angels outperformed the broad high yield market by 0.17% (1.31% vs. 1.15%), benefiting from a longer duration, and narrowing year-to-date underperformance to 1.98%. The 10-year US Treasury yield ended the month at 4.18%, a 0.10% decline during the month.

The Fed cut rates by another 0.25% earlier in the month, bringing the range to 4.50-4.75%, and with increased clarity following the U.S. elections, has set the stage for a potential follow-up 0.25% cut in December. Lower-rated credits (CCC & below) have outperformed higher-rated peers for five consecutive months, delivering an approximate 18% return year to date, with spreads trading in the low 700s (as measured in basis points). While this has driven underperformance for higher quality high yield such as fallen angels, it has also increased the downside risk of owning lower rated bonds as spreads hover near their tightest levels since the Global Financial Crisis.

We continue to monitor new fallen angel activity. Large potential fallen angels Boeing and Paramount continue to be multiple rating actions away from any potential downgrade to high yield, with the former on negative watch by two agencies and the latter with a negative outlook. However, we do expect an increase in fallen angel activity next year, driven largely by idiosyncratic factors, rather than a more systemic wave of downgrades. A major event or recession would change that outlook, but that is not our base case. Sell-side research has begun to provide their 2025 outlooks, which are all very similar in regards to credit migrations, stating that next year the expectation is more balanced backdropped with forecasts from $25-40bn both fallen angels while the rising stars range is $20-40bn. Looked at another way based solely on the number rating actions needed to become a fallen angel, the amount of BBB- debt at risk of downgrade to high yield has increased over the last few quarters to the highest its been since 2Q21, as detailed by J.P. Morgan (Exhibit 1).

Exhibit 1: BBB- Debt At Risk of Downgrade Has Risen

Source: J.P. Morgan, Dealogic. Past performance is not indicative of future results.

Another factor contributing to potential downgrades is the anticipated pickup in mergers and acquisitions (M&A) under a more favorable U.S. regulatory environment and lower interest rates. These transactions, often financed through debt, may increase leverage and weaken credit metrics that rating agencies evaluate. Fitch notes that M&A credit implications are mixed, but more often than not lead to a median one-notch downgrade. An increase in leverage does not guarantee downgrades, but could lead to credit deterioration, especially if they signal aggressive financial policies.

Fallen Angels Overall Statistics: Broad high yield spreads continue to trade near their tightest levels since the Global Financial Crisis as they reached 260bps in the middle of the month, and ended November at 274 bps which is just 33 bps off their all-time low (since December 2003). Fallen angel spreads also tightened to 234, 34 bps off the all-time lows that occurred in October 2021. Both fallen angels and broad high yield saw price increases.

Source: ICE Data Services, VanEck. Fallen Angels: ICE US Fallen Angel High Yield 10% Constrained Index. Broad HY: ICE BofA US High Yield Index. OAS refers to “option-adjusted spread.” Please see definition for this and other terms referenced herein in the disclosures and definitions portion of this blog. Past performance is no guarantee of future results. Index performance is not representative of strategy performance. It is not possible to invest in an index.

Fallen Angels: There were no new fallen angels in November.

Source: ICE Data Services, VanEck. ICE US Fallen Angel High Yield 10% Constrained Index. Past performance is no guarantee of future results. Not a recommendation to buy or sell any of the names/securities mentioned herein. Index performance is not representative of strategy performance. It is not possible to invest in an index.

Rising Stars: Marks and Spencer was upgraded to Baa3 from Ba1 by Moody’s, based on the company’s improved financial performance and strategic initiatives. Marks and Spencer was downgraded back in April 2020, entering the index at $91.57, providing a ~17% price return during almost 4.5 years. During the 12 months before the upgrade, Marks and Spencer price returned ~11% vs ~6% of the broad high yield market.

Source: ICE Data Services, VanEck. Fallen Angels: ICE US Fallen Angel High Yield 10% Constrained Index. Past performance is no guarantee of future results. Not a recommendation to buy or sell any of the names/securities mentioned herein. Index performance is not representative of strategy performance. It is not possible to invest in an index.

Fallen Angels Performance by Sector: All sectors within the fallen angel index posted positive returns for the month, with Financial Services posting the highest while Banking was the lowest. In terms of sector attribution versus a broad high yield, Telecom was the main contributor to outperformance, as Embarq Corporation, a main detractor in the first half of this year, has recovered following an upgrade in September despite still trading at distressed levels. Energy, Real Estate and Retail followed Telecom and were positive contributors to outperformance while the lack of Media exposure was the main detractor in November.

Source: ICE Data Services, VanEck. Returns are based on partial period data. Fallen Angels: ICE US Fallen Angel High Yield 10% Constrained Index. Not intended as a recommendation to invest or divest in any of the sectors mentioned herein. Index performance is not representative of strategy performance. It is not possible to invest in an index.

Fallen Angels Performance by Rating: No significant changes in the fallen angels rating allocation for November. The CC rated fallen angel, Embarq Corporation, outperformed higher and lower rated peers as it spread tightened significantly. Relative to the broad high yield market, fallen angel outperformance was primarily from the BB-rated issuers like Equitrans Midstream Corp and Rockies Express from the Energy Sector and Newell Brands from the Consumer Goods sector.

Source: ICE Data Services, VanEck. Fallen Angels: ICE US Fallen Angel High Yield 10% Constrained Index. Not intended as a recommendation to invest or divest in any of the sectors mentioned herein. Index performance is not representative of strategy performance. It is not possible to invest in an index. BB index: ICE BofA BB US High Yield Index; Single-B index: ICE BofA Single-B US High Yield Index; CCC & Lower rated index ICE BofA CCC & Lower US High Yield Index. *Doesn’t have securities for all months of selective periods. Returns are based on partial period data.