Boston - With over $100 billion of investment-grade bonds being downgraded to high yield during the first half of 2020, and some headlines calling for a multiple of that going forward, investors may wonder why IG yields have settled in near a record-low 2%.
This year, the usually staid investment-grade corporate bond market has made headlines reminiscent of the 2008 credit crisis. It started with the sharp March sell-off triggered by COVID-19, resulting in a drawdown that was surpassed only by the 2008 market collapse. Also newsworthy was the subsequent recovery in credit spreads that, when combined with the Federal Reserve rate cuts, helped propel IG bond returns to pre-pandemic levels.
Recessions, defaults and downgrades historically lag behind the business cycle, peaking after the cycle has begun to turn higher — a pattern likely to be repeated this time around. The business cycle is showing signs of entering the recovery phase, where economic trends and credit fundamentals begin to improve even though the economy continues to contract. Let's look at why this is good news for corporate bond investors.
What are fallen angels, and why they are important?
Bonds downgraded from investment grade to high yield are known as fallen angels. This distinction is important because many investment guidelines, including those of index funds, generally require that an investment manager sell a bond if the issuer fails to maintain a required minimum credit rating and therefore falls out of the IG bond index. In practical terms, a downgrade below BBB-, the lowest investment-grade rating, results in widespread forced selling. As a fallen angel transitions from investment-grade accounts that are now required to sell to high-yield accounts that are opportunistic buyers, the supply-demand imbalance pushes its price below fair value, resulting in significant underperformance relative to the rest of the IG market.
While defaults garner most of the headlines, we think avoiding fallen angels is much more important to holders of IG bonds, since it's rare for a company to declare bankruptcy while still maintaining an investment-grade rating. The performance drag is particularly notable this year: The broad IG index1 has returned 5% while fallen angels are down nearly -8%. This 13-point performance differential illustrates the importance of using fundamental research in an investment-grade portfolio to potentially avoid fallen angels.
How widespread were fallen angels in 2020?
Credit issues typically surface and downgrades increase when the economy enters a recession. Measures taken in the first half of 2020 to control the spread of COVID-19 placed severe pressure on the global economy, with companies in the commodity, retail, real estate and consumer-cyclical sectors hit particularly hard. The energy sector experienced the most fallen angels this year, with oil prices plunging due to the dual impact of the demand-destroying lockdowns and a price war that caused supply to surge.
How does the 2020 downturn compare with the 2008 credit crisis?
Through the first two quarters of 2020, more than 20 IG companies with $139 billion par amount of bonds outstanding have been downgraded from IG to high yield in 2020 — already exceeding the total recorded during the entire two years of the 2008 to 2009 financial crisis by $9 billion. While that par amount is a record in dollar volume terms, it represents only 2.6% of all outstanding investment-grade bonds due to the substantial growth in the market — far below the 4.2% downgrade rate in 2008.
The current recession is fundamentally different from the 2008 credit crisis, when financials were at the epicenter. The subsequent implementation of more stringent regulation has left banks entering the current downturn with nearly double the capital ratio they had in 2008. They're now in a stronger position to absorb losses, mitigating both downgrade and contagion fears. No 2020 fallen angel has defaulted so far, and almost all remain in the BB rating category.
How much more investment-grade debt is at risk of being downgraded?
With nearly 50% of the investment-grade market falling into the BBB rating bucket, the potential for downgrades continues to receive a lot of attention. We've seen forecasts for the total amount of fallen-angel debt this credit cycle ranging from $175 billion to $600 billion, with higher estimates including emerging market debt, such as the $58 billion issued by Mexico's national oil company, which was downgraded to high yield in April.
The pace of the downgrades has already lessened considerably over the last two months. As the second-quarter earnings season progresses, rating agencies will get a better understanding of the current state of credit fundamentals. Should the results beat expectations or indicate an upward trend, ratings agencies are more likely to view the current weakness as temporary and adopt a wait-and-see attitude.
At the end of June, companies whose debt traded above the average spread for BB-rated bonds had $30 billion par outstanding. We estimate that $80 billion of IG bonds are currently rated BBB- with a negative outlook such that a downgrade by just one agency would push them out of the IG index. These figures would be consistent with fallen angels totaling about $200 billion this cycle.
Which factors support the investment-grade market going forward?
Drawing on their experience during the 2008 credit crisis, the Federal Reserve intervened quickly and aggressively in March 2020 as the pandemic worsened and financial markets sank. Their decision to include IG bonds in this round of their quantitative easing program stabilized the market and led to a historic rally. The Fed recently finalized the terms of their primary credit facility, which will allow IG companies that have trouble accessing markets to borrow from them directly, thus helping to contain interest costs should spreads widen again. Future fallen-angel companies are eligible for these programs as well.
Companies have considerably improved their liquidity positions to see them through this recession. Issuance in the first half of 2020 exceeded annual issuance in most prior years. Proceeds are being used to build cash reserves and buttress balance sheets. Companies are also cutting costs, reducing stock buybacks and trimming capital expenditures in order to maintain their investment-grade ratings.
Finally, the economy is recovering much more quickly than the consensus forecasted. Employment is consistently surprising to the upside, manufacturing indexes are improving and fiscal programs have helped bolster the consumer. Clearly the progression of the COVID-19 virus will play an important role, but it appears that the near-complete shutdown of the economy in March and April may be unlikely to be repeated. Furthermore, major oil-producing nations have agreed to production cuts, relieving the pressure on crude oil prices, which have recovered to $40 per barrel.
Bottom line: Despite the likelihood of continued downgrades, the trend in credit fundamentals makes IG bonds an attractive investment alternative. An improving economy, innovative Fed programs and additional liquidity on corporate balance sheets suggest the worst of this downgrade cycle is probably already behind us, although the pandemic could easily change the trajectory of the current rebound. Expert fundamental research can be invaluable to IG investors in all market conditions, even now as the pace of downgrades slows from record levels.