INVESTMENT ACTIONS

Credit downgrades and fallen angels

01-Jul-2020
  • Gordon Readey
  • Tom Parker, CFA

The economic fallout from the coronavirus has caused seismic shifts across global bond markets. We believe that investors may face a prolonged period of increased credit downgrades and fallen angel activity for months to come.

A wave of credit downgrades

In the immediate wake of the virus, ratings downgrade activity in investment grade corporate bonds has increased significantly. In March 2020, more than USD$400 billion of investment grade debt was downgraded at least one notch by one rating agency.1

The monthly spike is similar in magnitude to other monthly surges during periods of market stress such as November 2008 during the Global Financial Crisis, the U.S. credit downgrade in September 2011, and the global oil sell-off in January 2016.

However, these downgrades as a percent of the Bloomberg Barclays US Corporate Bond Index (IG Index) outstanding, currently about 6% so far, are still lower than the most severe stressed periods we have seen historically. For example, November 2008 saw nearly 30% of the debt outstanding in the IG Index downgraded at least one ratings notch.2

Investment grade downgrades have spiked since the coronavirus outbreak

Monthly IG downgrade volumes and percent of index outstanding

Monthly investment grade credit downgrade volumes

 

Source: Barclays Credit Research, as of 3/31/2020. After 2012, IG downgrade volumes include companies downgraded by S&P, Moody’s and/or Fitch. Prior to 2012, volumes include only downgrades by S&P and/or Moody's. Index is the Bloomberg Barclays US Corporate Bond Index. Data only includes intra-index downgrades and not fallen angel bonds that have dropped out of the index. Indices are unmanaged and one cannot invest directly in an index.

Longer term, the actual pace of downgrades may change as rating agencies continue to evaluate factors including whether stay-at-home orders across the globe will have temporary or lasting economic impacts, and what low oil prices may mean for numerous industries.

A flood of fallen angels

So far this year, about USD$130 of U.S. investment grade corporate debt has been downgraded to high yield, with some projecting at least USD$200bn total over the course of 2020 (Figure 2). 3 For reference, USD$200bn is equivalent to about 3.5% of the overall IG index or 7% of BBB-rated bonds in the index.4

Fallen angel bond volumes may top highs in 2020

Fallen angel volumes and percent of index outstanding

Annual fallen angel bond volumes

 

Source: Barclays Credit Research, as of 3/31/2020. Index is the Bloomberg Barclays US Corporate Bond Index. 2020 estimate is based on Barclays Credit Research.

On the positive side, the Federal Reserve recently announced two credit facility programs to support the high yield market. However, these programs are limited to issuers that were investment grade as of March 22 and are U.S. based and/or have a majority of U.S. operations.

While this is stabilizing short-term, some longer-term fallen angel projections are as high as USD$700bn.4 Many of these downgrade projections have not yet been priced-in. We believe a wave of this magnitude would create lagged secondary and tertiary effects, especially in the case of a protracted recession. Fallen angel spread widening typically occurs well ahead of any rating downgrades, so we believe that investors need to start planning ahead.

Navigating credit markets in the wake of the coronavirus

While historic monetary and fiscal stimulus measures have helped restore liquidity to credit markets, it remains to be seen if governments are willing or capable of providing a lifeline to businesses whose debt load was not built to withstand such an economic shock. 

As we are only beginning to understand the potential long-term economic impact from the virus, we believe that this increased uncertainty can lead to both opportunities and risks for credit investors.

Going forward, we believe investors should consider defensive steps to limit the return drag that ratings downgrades can have on their investment grade portfolios. At the same time, a wave of new fallen angel bonds may provide opportunities for high yield investors if the economy begins to recover.

In this report we explore the current credit downgrade landscape and look at two different ways to navigate credit markets given this new environment.

Key takeaways

  • In the wake of the coronavirus, investors may face a prolonged period of heightened credit downgrade activity and fallen angel volumes.
  • Credit-screened strategies may help to reduce return headwinds caused by credit downgrades in portfolios.
  • A flood of new fallen angel bonds may offer an opportunity for investors who are currently rethinking their high yield allocations.
Tom Parker, CFA
CIO of Systematic Fixed Income
Gordon Readey
Senior Fixed Income Strategist
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  1. 1. Source: Barclays Credit Research, “Downgrades are Piling Up”, 4/17/2020.
  2. 2. Source: Barclays, Credit Research, “Not All Fallen Angels are Getting Wings”, 4/17/2020.
  3. 3. Source: Bloomberg Barclays Indices, as measured by the Bloomberg Barclays US Corporate Bond Index, as of 3/31/2020.
  4. 4. Source: Morgan Stanley, Investment Grade Credit Strategy, “Sizing Downgrades”, 4/17/2020.

 

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