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Are fallen angels about to descend on the high-yield market?

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Kelley G. Baccei, High Yield Portfolio Manager, Eaton Vance Management

      Boston - Over the past few months, various media outlets have warned of a wave of "fallen angels" possibly flooding the high-yield corporate debt market as BBB-rated, investment-grade issuers have taken on large debt loads over the past few years. In this blog post, we'll explain why we think those fears are overblown.

      GE bonds in focus

      The concerns swirling around General Electric (GE) and the widened credit spreads on its bonds have further fueled the speculation of a potential rush of fallen angels. The Wall Street Journal recently compared the possible downgrade of GE into high-yield "junk" territory to the downgrades of Ford and GM in 2005, which amounted to approximately $87 billion in downgraded bonds flowing into the high-yield market. (A fallen angel is a bond that has seen its rating slip from investment grade to high yield.)

      The threat of GE debt entering the high-yield index is certainly concerning. With $48 billion in index-eligible bonds, it would be the single largest fallen angel in history. The high-yield universe currently stands at $1.2 trillion, so the impact of absorbing GE issues would be relatively muted at 4%, but nevertheless meaningful.

      However, we believe the problems within GE are firm-related, and not a sign of struggles in the broader economy. Also, there are steps that can be taken to restructure the company to remediate market concerns and any further ratings changes.

      Silver linings?

      We are in the camp that views the risk of BBB-rated issuers migrating into the high-yield universe in the near-term as low. Although leverage has increased in this part of the rating spectrum, in our view the risk of a recession in the near-term is relatively low, while average revenue and earnings growth of this cohort has been relatively healthy.

      We believe the downgrade risk of BBB-rated issuers will likely remain isolated to structurally-challenged sectors and issuers, such as retail and autos. Another positive indicator is that the number of BBB-rated financials (which are historically more sensitive to economic downturns) has not grown meaningfully since the financial crisis, and banks have better capital and liquidity buffers in place.

      Blog Image HY Downgrade Risk Nov 29

      Another silver lining is that although the number of bonds which are both rated BBB- and currently on negative outlook has grown, this can act as a catalyst for firms to reduce leverage to preserve their investment-grade rating. The volume of bonds rated BBB- which are currently on "downgrade watch" only equates to 1.3% of total outstanding bonds rated BBB-. This is the lowest level since December of 2013.

      Blog Image BBB Issuers Nov 29

      At the same time, the percentage of bonds rated BBB- which are on "upgrade watch" is at an all-time high. This figure sits at roughly 8.2%, versus the 10-year average of 3.6%.

      While there is always potential for fallen angels to enter the high-yield market (roughly $40 billion has entered so far in 2018), we don't believe that the situation is an immediate concern. As active managers, we have identified several issuers that we would be interested in if a downgrade into the high-yield universe was imminent.

      The high-yield market has faced headwinds this quarter as markets began to price in some of the risks that we have been leery of for some time, such as rising interest rates, the unwinding of quantitative easing (QE), global trade policy, Brexit and Italy. Spreads have widened over 100 basis points after reaching post-crisis tights in October.

      The riskier parts of the high-yield market (issues rated CCC and lower) have suffered the most, after outperforming for much of the last couple years. The rapid retreat in oil prices has also had a significant impact.

      Bottom line: Despite the high-yield headwinds discussed above, we believe that the fundamentals at this point remain supportive. Defaults are benign at 2% and we don't see them rising much in 2019, if at all. Leverage is near post-crisis lows and interest coverage is at all-time highs. Peak earnings growth is likely behind us at this point, but we believe the fundamental picture for high-yield issuers remains supportive.