Fallen Angel Bonds: A Record Year Ahead?

The unexpected economic shock caused by the COVID-19 pandemic has led credit investors to reset previous expectations for a relatively benign credit environment this year. We had expected an uptick in fallen angel high yield bond volume compared to the trickle of recent years, driven by company specific credit events from within the outsized BBB rated universe. However, systemic risk has increased significantly in recent weeks and a broader wave of downgrades now appears inevitable.

Rating agencies have already started to act, resulting in approximately $90 billion of index eligible fallen angels year to date. This already puts 2020 nearly on par with 2005 as the highest calendar year ever for fallen angel volume.

Year to Date Fallen Angel Issuers:

Source: VanEck and ICE Data Indices as of 3/26/2020. Estimated weight assumes that all expected fallen angels are included in the overall market value of the ICE US Fallen Angel 10% Constrained Index.

Forecast: Up to $300 Billion of Fallen Angels

With the significant but still unknown impact to growth from the pandemic, as well as the potentially prolonged effect on the energy sector from the Saudi/Russia oil price war, our base case is for $250 to $300 billion of fallen angel volume this year measured at current market value, which is $300 to $360 billion in terms of par amount. This includes the approximately $60 billion that occurred in the last week of March alone but has not yet entered the index.

This forecast recognizes the significant amount of leverage that has built up within the investment grade space, which has been manageable under the slow but steady growth enjoyed up until recently. However, the credit cycle has now turned and even a modest downwards adjustment in growth would reasonably be expected to result in an increase in downgrades.

Our forecast also assumes that certain sectors under stress may experience multiple ratings actions, and that the market’s assessment of credit quality is currently far ahead of the rating agencies in some cases. At the same time, the extraordinary measures already announced by the Federal Reserve and the fiscal stimulus recently passed by Congress will likely prevent the worst case scenarios from being realized, in our opinion.

We analyzed three scenarios to provide a range of possible outcomes which help to inform our forecast, and provide a range of possible outcomes under various assumptions and iterations:

Scenario 1: Assume that bonds that are one 1-notch downgrade away from becoming high yield become fallen angels.

Scenario 2: Similar to scenario 1, but for certain sectors of concern (Energy, Autos, Capital Goods, Financial Services, Basic Industry, Leisure, Transportation and Retail), assume that bonds that are two or three downgrades away from becoming high yield also become fallen angels.

Scenario 3: Assume that bonds trading at or above the average BB spread become fallen angels.

Volumes Will Be Significant Under Any Scenario

The scenarios above are inclusive of the over $60 billion of new fallen angels expected to enter the index based on recent ratings downgrades.

Downgrades Will Impact Sector Exposure

Sorted by current weight, sectors that experience notable increases under the various scenarios are highlighted below.

Although Scenario 3 appears most severe in terms of the resulting energy exposure, there could also be instances where energy makes up an even higher percentage. Keep in mind that both the coronavirus impact on growth, as well as the Saudi/Russia price war, are impacting that sector, so there is a possibility of a broad, quick recovery while energy continues to lag.

There is currently about $300bn of BBB rated energy debt, $120bn of which is rated BBB-. However, within energy, we expect the fallen angel universe to continue to remain differentiated from the broader market with an overweight to midstream names. Notable potential fallen angels include Plains All American in Scenario 1 and Enterprise Transfer Partners and Williams Partners in Scenario 2. The weight of integrated oil companies, which previously had no representation in the fallen angel universe, would increase with the addition of Occidental Petroleum and Hess Corporation in all three scenarios.

Potential Large Fallen Angels

The 10 largest new fallen angels, excluding the recent fallen angels that are already expected to enter the index based on recent downgrades, and their weights (assuming, unrealistically, that all potential downgrades occur simultaneously) are below:

Scenario 1:

This scenario is characterized by a significant increase in media exposure, driven by the entrance of bonds from Charter Communications and Spectrum. The increased exposure to the healthcare sector is driven by the expected downgrade of HCA in this scenario. Although Ford has already reached fallen angel status, no other large automaker is expected to be downgraded in this scenario. Within banking, Ally Financial would be a fallen angel in this scenario as well as certain bonds issued by Lloyds Bank, but no other large, notable entrants are expected in that sector.

Scenario 2:

With the assumption of additional downgrades in the most impacted sectors, energy names dominate the list of largest expected fallen angels in this scenario. Although further stress was also applied to basic industry and autos, we do not see General Electric Boeing, or General Motors downgraded to high yield in this scenario. Several large issuers in the financial services space could become fallen angels, particularly companies involved in aircraft leasing; the two largest are Aercap and Avolon.

Scenario 3:

General Motors would be a fallen angel under this scenario, increasing automotive exposure to 14%. Deutsche Bank bonds would also be downgraded. This market based analysis is heavily dependent on market conditions when the analysis is run. Only a few days prior to this analysis, both Boeing and General Electric would also have become fallen angels.

A Record Year for Fallen Angel Bonds?

The high yield market has not grown significantly, leading some to wonder whether it can absorb a substantial amount of new fallen angels. We believe it can. The lack of significant growth suggests there is pent up demand in the high yield space for new paper that will also help diversify the opportunity set.

Further, although the high yield bond market has not grown in line with the investment grade universe over the past decade, there is a broader leveraged finance universe, including loans, private debt and distressed debt focused hedge funds. Many of these market participants, we believe, will come into the high yield bond market given the severe dislocation that has and will continue to provide pockets of opportunity. However, the investment grade bond space is much larger, and prices will need to adjust to a level that is attractive to high yield investors given that investment grade mandates generally cannot or will not hold fallen angels.

For fallen angel investors, the combination of a significant increase in volume and lower bond prices may present an extremely attractive opportunity. Strong absolute returns and significant outperformance relative to broad high yield strategies have historically followed periods of increased fallen angel volume, because a fallen angel strategy buys oversold bonds and goes overweight sectors where fundamentals have bottomed out.

The higher fallen angel volume there is, the greater the opportunity to potentially benefit from subsequent price recovery. Our base case assumes that this will be the biggest year for fallen angels on record. This opportunity does not come without risk. Near term volatility is likely, and investors will need to be willing to go overweight out of favor issuers and sectors. An increase in defaults may be likely, but this is already priced into current valuations, in our opinion. This risk may be further mitigated by the higher quality tilt of fallen angels versus the broad high yield market.