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Fallen Angels: Heaven or Hell?

Much like the angels cast out of heaven according to Judeo-Christian doctrine, fallen angels are high-yield corporate bonds that, at the time of issue, were deemed to be investment grade, but have subsequently been downgraded to sub-investment grade. Considering the current low interest rate environment, and since high-yield bond spreads have spiked by 2.75% since the end of last year, fallen angels have become an increasingly popular asset class amongst those investors looking for greater returns and diversification within the covid-related economic downturn. This article considers some of the driving factors behind fallen angels, and the implications of this trend for bond markets and businesses. 

The rise of fallen angels

As of July 2020, roughly $130bn of US investment grade corporate debt had been downgraded to sub-investment grade, with some analysts projecting a total of at least $200bn worth of investment grade debt to be downgraded by the end of 2020. For a sense of scale, $200bn equates to around 3.5% of the overall investment grade index. Although, such predictions have yet to materialise. 

Thus far, over 30 companies have been downgraded from investment grade to sub-investment grade this year. Due to both demand-side and supply-side pressures presented by COVID-19, such as national lockdowns and travel restrictions, some industries have been greatly affected; namely, the automotive, energy, retail, leisure, hospitality, and aviation sectors. High-profile downgrades this year include Kraft Heinz, Macy’s, and British Airways. Most notably, the downgrade of Ford Motor Company contributed $36bn worth of junk bonds towards global high-yield debt. 

The reasons underpinning downgrade decisions are often specific to individual firms and their business models. However, Moody’s — the credit rating agency behind many of the downgrades witnessed this year — attributes the trend in fallen angels to factors related to COVID-19, a crash in oil prices, and a generally weaker global economy. These factors combined have led to major credit shocks across a number of sectors and markets. 

Central bank support for fallen angels 

In April this year, the Federal Reserve made the unprecedented decision to include the purchasing of fallen angel bonds under its Secondary Market Corporate Credit Facility, in order to prop up companies hit hardest by COVID-19. Markets generally received this news positively, indicated by a surge in the price of HYG — the largest exchange-traded fund tracking the high-yield market — from $77.3 to $83 following the announcement. Such levels of central bank support have instilled confidence in the US bond market, benefitting both fallen angel companies and investors. Throughout August, more than 60% of the Federal Reserve’s bond purchases were issued by auto companies; Ford included. As a result of such measures, US debt markets have been rather lively throughout Q3 2020, and investors have not yet rushed to abandon their junk bonds. In Europe, the European Central Bank did not opt for a similar bond purchasing programme, but have decided to accept fallen angel bonds — no more than two notches below investment grade — as collateral. Whether or not central banks continue to support bond markets, and the extent to which they do so, will play an important role in shaping capital markets in years to come. 

Fallen angels as investment instruments 

Whilst high-yield debt is typically considered too risky for most investors, some investors have embraced fallen angels as a means to create a robust and diversified portfolio. As discussed, fallen angels offer investors diversification benefits and, all things being equal, may be more favourable than regular high-yield bonds within a given sector. Historically, fallen angels have produced higher risk-adjusted returns than regular high-yield bonds. One reason for this may be due to fallen angels being more likely to upgrade in the near future, compared to legacy high-yield companies. Furthermore, fallen angels historically have seen lower default rates than regular high-yield bonds. These factors, in turn, may be explained by the reliable nature of fallen angel companies, many of which enjoy plenty of tangible assets, strong cash flow, state backing, and globally-recognised branding. 

Mitigating the impact of fallen angels on businesses 

It may be challenging for firms to find buyers for fallen angels in the upcoming months, as demand for high-yield bonds is generally more limited. The $6.7tn investment-grade bond market is far larger than the $1.2tn high-yield bond market. From a corporate advisory perspective, it is thus important to note that companies, like Ford, whose credit ratings have deteriorated amid this year’s economic turmoil, may now face difficulty finding access to funding. Whilst low interest rates mean that fallen angels have reasonable flexibility around financing options, borrowers nonetheless may find that new debt must be issued on terms that appeal to investors, such as better pricing and greater collateral. Moreover, such companies may struggle to navigate the rest of the year due to an increased cost of debt funding and narrower finance margins. To mitigate the negative impact of fallen angels on companies, firms should address inefficiencies within underperforming divisions, look for cost-saving opportunities in their business models, and deploy capital more effectively. 

Considering the rather bleak expectations laid out earlier in the year as to how the fallen angel trend would unfold, the situation has turned out better than anticipated. Despite the financing difficulties firms may face in forthcoming months, temporary support from central banks means that the consequences of fallen angel activity are far from doomsday predictions. 

Sources

https://www.vaneck.com/uk/en/blog/etf-insights/fallen-angels-from-sin-to-win?country=UK&audience=retail

https://www.ft.com/content/c6c904be-53f4-11ea-90ad-25e377c0ee1f

https://www.ft.com/content/72641a3f-5c11-40b1-923a-7aeefbb89d7f

https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/moody-s-downgrades-ford-motor-credit-signals-review-for-further-rating-cut-57775517

https://debtexplorer.whitecase.com/leveraged-finance-commentary/lenders-calm-despite-fallen-angel-risks?_lrsc=b84e1990-0208-448c-8224-cd40f5e29808&trk=&utm_source=linkedin&utm_medium=linkedinelevate#!

https://www.bloomberg.com/opinion/articles/2020-04-09/coronavirus-fed-is-seizing-control-of-entire-u-s-bond-market

https://www.ecb.europa.eu/press/pr/date/2020/html/ecb.pr200422_1~95e0f62a2b.en.html

https://www.blackrock.com/institutions/en-gb/insights/investment-actions/credit-downgrades

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