Over $230 billion of bonds has been downgraded from investment grade to high yield so far this year, smashing the previous record for so-called fallen angels. We think this is just the tip of the iceberg.
We expected 2020 would be a big year for fallen angels even before the coronavirus pandemic dampened the global economic outlook. Of the downgrades so far, we had expected over half of these due to a variety of company-specific factors, long before we had ever heard of COVID-19.
As we discussed in our blog last year, a large number of companies were already in a vulnerable position in the run up to this downturn, with leverage elevated following mergers and acquisitions and the rating agencies demanding substantial debt reduction in order to justify their investment-grade ratings.
We’ve revisited this analysis, once again looking at the entire investment-grade market across euros, sterling and dollars from a bottom-up perspective. This time we’ve based our stress testing on the economic scenarios from Tim Drayson, our head of economics.
Even in Scenario 1 (a best-case V-shaped recovery), we expect the fallen-angel tally to grow to around $500 billion over the next one to two years, comfortably surpassing the previous two-year record from the 2015-16 energy-market crisis. The $750 billion and $1.2 trillion figures under Scenarios 2 (a U or W-shaped recovery) and 3 (a prolonged recession) dwarf all historical comparisons.
One reason for the staggering numbers is that credit markets have grown substantially over the past 10 years. But even when we look at fallen-angel volumes relative to the overall market, in all scenarios other than a V-shaped recovery, this downturn looks set to eclipse the global financial crisis.
There’s no such thing as a ‘typical’ economic downturn, but the COVID-19 crisis clearly has some unique characteristics, and certain industries and companies are disproportionately affected by the pandemic. For example, while we would have expected travel and leisure to suffer in any economic downturn, we would not ordinarily have predicted this would happen so quickly or aggressively. Similarly, oil-price weakness is typical in a recession, but not on the scale that we have witnessed over the past few months. Essentially, COVID-19 has resulted in multiple crises at the same time.
When thinking about fallen angels, this crisis requires investors to look beyond the ‘typical’ low BBBs that might be nudged into high-yield territory in an ‘ordinary’ downturn. In Scenario 2 (a U or W-shaped recovery), our expected fallen angels would suffer an average downgrade of two notches from their rating at the start of 2020; some companies would fall as much as seven notches lower than their original rating. This means that nearly $100 billion of our expected fallen angels were rated mid-BBB or higher as recently as January. That figure increases to almost $300 billion in Scenario 3 (a prolonged recession).
This all means that some credits and sectors that were once considered safe havens could prove less resilient than expected. But the good news for investors is that we think there is still time to take action to avoid some of these vulnerable bonds. With companies reluctant to give guidance and rating agencies waiting for clarity before the next wave of downgrades, the market has not yet fully priced the credit impact of COVID-19 and may need more time to do so.
This creates price discrepancies across a wide range of sectors and rating categories, which we believe could present exciting opportunities for active fund managers in investment grade and high yield alike.