Fallen angels – the impact on Fixed Income markets

The number of bonds that have actually been downgraded to high yield from investment grade (fallen angels) has risen dramatically as ratings agencies assess the impact of the crisis on corporates.

The unprecedented measures taken by governments across the world aimed at slowing the spread of COVID-19 has significantly impacted economic activity. Prior to the emergence of this pandemic, much had been publicized about the re-leveraging and general deterioration in quality that was occurring in high grade corporates. For example net leverage, as represented by Net Debt to EBITDA ratio had increased from 1.1 in 2011 to 1.9 in 2019 in US corporates according to data from Morgan Stanley. Additionally, the lowest quality tier of the high grade debt universe for example bonds rated BBB, had steadily increased from 30% of the overall market at the end of the 2008/09 financial crisis to roughly 50% today as the chart shows.

Although credit rating agencies have selectively downgraded a number of issuers from investment grade (IG) to high yield (HY) over the past few years, the focus was often on borrowers in a handful of sectors such as energy and metals and mining. What seemed to be missing was a catalyst that would trigger a broad based wave of so-called "’fallen angels’, a term used to described bonds that have been downgraded from investment grade to non-investment grade – enter COVID-19 and the collapse of oil prices.

The disruption to economic activity has been staggering with almost all sectors and industries feeling the impact of a global economy at a near standstill. Expectedly, the number of bonds that have actually been downgraded to HY and the number that currently have a rating of BBB-, the last notch within IG, have both risen dramatically as ratings agencies assess the impact of the crisis on corporate balance sheets. For instance, S&P has already stripped 21 companies of their investment grade rating since February of this year, the highest such tally since 2015. Simultaneously, the universe of borrowers it has rated BBB- with a negative outlook (potential fallen angels) currently stands at 96, the highest since March 2009.

While European and US corporate issuers have garnered most of the attention in regards to fallen angels, developments in other areas especially in the Emerging Markets – and to a smaller extent – developed Asia, all point to rising downgrade risks. South Africa's loss of its only remaining investment grade rating last month and Mexico's recent downgrade to BBB- by one of the three major agencies both have significant ramifications for the corporates and quasi-sovereigns in those economies.

In this commentary we share a number of key findings from a recent study conducted by our credit research team on the par amount of likely fallen angels across Europe and the US in the next three to six months. We then examine the impact of these potential downgrades on credit markets and conclude with our outlook and positioning.

Global corporate bonds historical rating distribution

The above estimates are not dissimilar to what the broader market expects. However, the situation remains fluid and dependent on several exogenous factors such as the length of lockdowns imposed in various countries and the nature of any potential exit paths. We will therefore continue to reassess market conditions and update our forecasts as the current environment evolves.

Investment Grade

Many fallen angel candidates are already trading at HY levels. For example, at the end of March our expected fallen angels for Europe were trading at 460bps, broadly in line with HY bonds rated BB+/BB. This is in stark contrast with bonds rated BBB and BBB- which traded 360 bps tighter back in January this year. One notable exception to this trend of spread widening in IG can be observed in the US where trading levels have rebounded meaningfully following the announcement by the US Federal Reserve (Fed) that it would begin buying fallen angels as part of its broad-based measures to support markets. Going forward we expect this intervention to provide a floor to pricing levels for US fallen angels with some nuances across sectors.

Compared to the global financial crisis (GFC), the fiscal and monetary support programs being enacted by central banks in response to the current challenges are helping restore order to credit markets. It is also worth noting that banks are healthier today than they were back in the GFC. They have stronger capital and liquidity buffers and we therefore expect a significantly lower incidence of downgrades of subordinated bank debt to high yield. Additionally because banks are in better health, compared to 2008/09, they are in a much stronger position to support businesses during these difficult times.

High Yield

Whilst the absolute amount of fallen angels in Europe is forecasted to be lower than in the US, when compared to the size of the respective HY markets, Europe is expected to feel a heavier impact from downgrades. Based on our analysis the EUR HY market is expected to incur an increase in size of close to 50%. This compares to an increase of just over 25% in the US HY universe.