January 2020
Fallen Angel: When an investment-grade bond is relegated to the high yield universe
Trustees overseeing institutional portfolios typically allocate a significant portion of assets to investment-grade corporate bonds. Why is this? Most importantly, corporates have historically offered a higher level of returns than government bonds with a similar risk profile over the course of market cycles. This contrasts with high yield bonds, who have historically offered a higher level of returns than government bonds, but with a markedly high level of risk similar to equities. Additionally, corporates have offered diversification against other components within portfolios, equities and alternative assets, allowing for better risk-adjusted returns over time.
An increased appetite to corporate debt is one factor leading to the growth over time in the space. Since 2001, the investment-grade corporate debt market has grown and evolved significantly, with a total market value in 2001 of approximately $2 trillion and a current market value of over $10 trillion.
Over this same period of time, the bottom rung of the quality of the investment-grade ladder has ballooned. BBB-rated bonds represent over 50% of global investment grade debt versus only 17% in 2001.
Compounding the concern of heightened risk is the fact that the creditworthiness of investment-grade corporates has weakened by historical standards. The world’s largest bond manager, BlackRock, offered their perspective on the changing bond market in a recent research report:
“We believe the sharp increase in the proportion of BBB-rated constituents has made the investment-grade bond sector riskier than in recent years. BBB-rated bonds are typically the most vulnerable of all investment-grade debt in a recession. Any downgrade of such bonds would relegate them from the investment-grade to the high yield universe making them “fallen angels” and re-rate their value.
Portfolios constrained to invest only in investment-grade debt would likely be forced to sell the holdings, potentially further eroding the bonds’ value.”
They further quantified the risk of downgrades by examining the price impact of “fallen angel risk” over three-month return periods. Looking back over the past 20 years, they found that fallen angel bonds declined sharply in the three months prior to being downgraded. This created a drag on the returns of the overall market of U.S. investment-grade corporate bonds. In some years, fallen angel bonds detracted only 0.05% while in 2016 they cost over 2.5%. Furthermore, the potential impact of downgrades varies and the magnitude can be influenced by the stage of the credit cycle. In late-cycle environments such as the late 2000s, high yield default rates tend to increase, the percentage of fallen angels can rise, and the impact on performance can be pronounced. Cumulatively, the performance drag can be significant for investment-grade portfolios.
It is important to understand the composition of the BBB group and the drivers that contributed to its rapid growth. Three main groups drove growth in the space: banks, energy and non-cyclicals.
Banks make up over 20% of BBB debt and grew following the Great Financial Crisis as a result of heavier scrutiny. However, as a result of this increased scrutiny, many banks have taken measures to display better capital discipline and balance sheet health. Following the energy crisis in 2016, there was a wave of downgrades, though it can be argued that energy companies have maintained financial discipline and avoided risk-taking, even following the recovery in oil prices. The final group to have contributed most to the growth of BBBs are non-cyclicals like Consumer Staples, Communications and Healthcare. These are considered defensive industries due to their ability to maintain earnings stability in economic downturns. Thus, they are less likely to experience the severe deterioration in credit quality that leads to falling into high yield. They are also more likely to be large multi-national corporations with very large capital structures and are incentivized to maintain investment grade status. These issuers will not become fallen angels without a fight.
The investment-grade corporate bond market has experienced material change and the potential for fallen angel risk has grown substantially, underscoring the need for active management strategies designed to provide defensive characteristics even in an asset class traditionally believed to be “safe.” Managers not only can provide diversification across issuers, industries, sectors and ratings, but also can add value through security selection and the avoidance of issuers who may offer higher levels of risk relative to peers. Screening for credit quality by active managers is essential in order to deliver downside protection in volatile markets and shifting credit and business cycles.
