Industry fears market turbulence will lead to surge in 'fallen angels'
Covid-19 and oil price plunge spook investors
Concerns surrounding an increase in 'fallen angels' have ramped up amid the recent market turbulence, according to fixed income investors, who warn that debt at the lower end of the investment-grade spectrum is most vulnerable to being downgraded and relegated to the high-yield market.
The combination of the Covid-19 crisis and plummeting oil prices have rattled markets and are driving the global economy towards a recession.
While the US Federal Reserve's unprecedented move last month to buy corporate bonds has been well received, it is not seen as being sufficient to prevent widescale downgrades.
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Sean Markowicz, strategist, research and analytics at Schroders, has estimated between $277bn to $561bn of BBB debt could be downgraded, with losses at the investment grade index level of between -1.2% to -4.1%, based on historical experience.
However, he added this does not take into account the "significantly higher proportion of BBB-rated debt today compared to the past", while Schroders expects the global recession to be the worst since the 1930s Great Depression.
"As a result, these projections may understate the potential losses that investors could be exposed to," he said.
In the European high-yield market, where there is currently €221bn of debt outstanding in the BB space, representing 70% of the index, Mark Benbow, co-manager of the Kames High Yield fund, said we could see "anywhere from a 25% to 75% increase in the size of European high yield over the next 12 months", adding some sell-side estimates have it doubling in size.
Indeed, Aviva's head of UK investment grade credit James Vokins said around 20% of BBB-rated credit is "within one or two notches" from being downgraded to high yield.
Avoiding fallen angels in the credit sector
Vokins added there have already been several high-profile BBB-rated bonds, such as Ford, dropping down to high yield in the past month.
"We think this trend will continue and exceed the volume of 'fallen angels' seen in 2008 and be more akin to the shorter, sharper downgrade migration of 2001 where around 10%-20% of BBBs moved into high yield," he said.
"However, rating agencies also cite looking-through current earnings weakness and highlighting companies with plenty of liquidity to fund themselves during this crisis."
Market disruption
Janus Henderson's Nick Maroutsos, co-head of global bonds, warned that excessive downgrades could be disruptive for the market.
"Downgrades are tricky because in my view it could put a tonne of further pressure on the market," he said.
"I have to think the ratings agencies will be a little more forgiving, despite their claimed independence. This could be a combination of looking through this current environment or being less punitive in their downgrades.
"The knock-on effects of significant downgrades would be huge. It will lead to forced selling across multiple platforms that are not allowed to hold high yield: indices, passive funds/ETFs, active managers, pensions. It would make it much worse."
Flows into fixed income funds slow as investors turn to global equities
Schroders' Markowicz also highlighted that investment grade downgrades in the US could have "a much bigger market impact than in the past" as the BBB-rated part of the US investment grade market has risen to 47% from 33% in 2008.
However, he added potential downgrades have widely been priced in.
"Investors have moved swiftly ahead of rating agencies in pricing in potential downgrades. As at 27 March, the average credit spread on US BB debt, the top tier of high-yield debt, was around 660 basis points.
"But about $347bn of BBB debt traded at a higher spread than that, representing 10% of total outstanding BBB debt."
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