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    Fallen angels or falling knives?

    Fallen angels or falling knives?

    May 18, 2020 Fixed income

    Just before the global pandemic, we published Don’t be afraid of BBB credit. What follows is an updated perspective on BBBs and fallen angels in light of the great lockdown.

    Fallen angels: theory to reality

    As a direct result of COVID-19, the threat of an increase in fallen angels has materialized, with large capital structures like Ford (~$40bn)1 among the first to be impacted.

    Approximately $150bn of BBBs have been downgraded year-todate, and we would not be surprised if the year-end total is double this as another $300bn2 is already on negative outlook.

    So now what? Separate the fallen angels from the falling knives

    After a downgrade, some fallen angels may offer potential opportunities amid forced selling from passive funds, as long as the company will still be able to repay at par. Others though may be on the way to distress or default – and so would just be falling knives – and best avoided.

    The potential opportunity typically occurs just after fallen angels’ transition from investment grade to high yield indices (usually the end of the month of the downgrade). In our experience, we see that they tend to underperform (i.e. widen relative to) their investment grade peers just before the transition, but they tend to outperform (i.e. tighten relative to) their new high yield peers just after the transition (Figure 1).

    Figure 1: Fallen angels tend to outperform just after an index transition3

    Fallen angels tend to outperform just after an index transition

    Source: Credit Suisse, April 2020.

    We believe an investment grade strategy could potentially benefit from investing in the right fallen angels just after a downgrade – if investors can properly identify companies with the liquidity, balance sheet strength and ultimately, staying power to avoid a default. Investors need to be in a position to take advantage quickly, such as already being invested in a vehicle that can seek such opportunities.

    Figure 1 also demonstrates the potential value of not holding a BBB name that is about to be downgraded.

    Avoid BBB downgrades: identify riskier sectors

    Sector allocation can be an important first step for seeking opportunities within BBBs and avoiding downgrades.

    Recent fallen angels have been concentrated within sectors such as energy and autos given plummeting demand for oil or travel. Sectors less exposed to economic shutdowns have fared much better so far (Figure 2).

    Figure 2: Fallen angels year-to-date have been concentrated in certain sectors

    Fallen angels year-to-date have been concentrated in certain sectors

    Source: JP Morgan (ex-EM issuers), May 2020.

    We therefore believe avoiding downgrades is better achieved through an active investing strategy that can make sector allocation decisions. The table below illustrates which sectors we think will remain the most exposed looking ahead.

    Which sectors are potentially most insulated or exposed to COVID-19 disruption?

    Low exposure Moderate exposure High exposure
    Technology: Biotech, software Banking Transportation: Airlines
    Telecoms: Cable/Satellite/Wireless

    Capital Goods: Electrical Equipment, Forest
    and Paper Products, Machinery Manufacturing and Industrial

    Automotive: Manufacturing

    Finance: Consumer (Banking middle office),
    Property and Casualty Insurance

    Media/Entertainment: Content Leisure/Gaming/Hotels
    Consumer: Food and Beverage Finance: Other Basic Industry: Chemicals, Construction Materials Manufacturing
    Healthcare/Pharmaceuticals Health Care: Facilities and Services Finance: Consumer

    Media/Entertainment: Internet, Publishing
    and Broadcasting

    Energy: Metals and Mining, Pipelines,
    Power Generation

    Energy: Exploration and Production, Integrated Oils, Refining
    Retail: Supermarkets Transportation: Railroads, Other Finance: Life Insurance

    Utilities: Waste and Environment Services
    and Equipment

    Real Estate Consumer: Discretionary
      Utilities  

    Source: Insight Investment, for illustrative purposes only.

    Exploit growing BBB market dispersion for opportunities

    It may seem best to de-prioritize allocations to challenged sectors, but those sectors may offer the best security selection opportunities.

    The threat of downgrades has driven a rise in price dispersion across BBBs. This has made it more of a security selector’s market (Figure 4).

    Figure 4: US BBB security level dispersion has risen

    US BBB security level dispersion has risen

    Source: Barclays, April 2020.

    Furthermore, we believe the best of these individual opportunities may actually be within the challenged sectors mentioned above. As volatility is elevated within those sectors, many good quality individual credits are most likely to have been unfairly caught in the crossfire and sold off without justification. A bottom-up credit focused approached will potentially uncover the best of these opportunities.

    BBBs - so why now?

    1. Valuations are historically wide
      Given the sudden increase in downgrade risks, BBB credit spreads are wider than they have been for 96% of their history3. At almost 2.9%, they are almost three times wider than they were at the start of the year. For comparison, at the start of the year BB spreads were 2% and Bs were 3.5%4.

      If investors can find well-capitalized companies with staying power among the herd, they have the potential to lock in higher spreads without moving down the credit risk spectrum.

    2. Don’t fight the Fed?
      The Federal Reserve (Fed) is providing an unprecedented level of monetary stimulus, for the first time even launching programs offering direct stimulus to corporate debt.

      The Fed is also now the first major central bank committed to supporting fallen angels by putting them on its shopping list, provided the entities were investment grade on March 22. This is a technical tailwind and a factor we expect to will improve the staying power of a number of entities. We expect the tailwind will be bolstered by institutional buyers, such as LDI investors, taking advantage of corporate valuations.

    3. Record issuance potentially means more staying power
      Even though the Fed is only at the very early stages of purchasing corporate debt, new issue volumes have smashed records largely in anticipation of the central bank’s new measures. March and April were, by far, the busiest months of US primary corporate investment issuance on record, and May is looking to set another all-time record5.

      For example, the previously mentioned Ford (which is eligible for the Fed’s purchases) – was able to return to the primary markets after its downgrade with a new 3-part $8bn deal that received $41bn of orders.

      This has helped corporations raise liquidity, providing a potential measure of protection against a protracted period of business disruption. Liquidity is on the top of our checklist of ‘landmines’ to watch for signs of credit distress or default.

    The sell-off was correlated, but the recovery won't be

    The COVID-19 shock may have resulted in a broad-based sell off across risk assets – but as with previous crises – we believe the recovery will be less uniform. Picking the winners will be key.

    Until more clarity is available on the effects of the great lockdown, the depth and shape of the downturn and its impact across sectors – it’s important to keep an eye on the big picture. Those with staying power, strong balance sheets and robust liquidity positions currently offer the best combination of relative value and defense against economic uncertainty in our view.

     

     


    1The mention of a specific security is not a recommendation to buy or sell such security. The specific securities identified are not representative of all the securities purchased, sold or recommended for advisory clients. It should not be assumed that an investment in the securities identified will be profitable. Actual holdings will vary for each client and there is no guarantee that a particular client’s account will hold any or all of the securities listed.

    2JP Morgan, May 2020.

    3, 4Bank of America, Merrill Lynch, May 2020.

    5Bloomberg, May 2020.

    Please note: any forecasts or opinions expressed herein are Insight Investment's own as of May 6, 2020 and subject to change without notice.

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