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European high-yield bond market sanguine in face of rising fallen-angel risk

The major rating agencies are being proactive in addressing outlooks and ratings changes to account for the impact of COVID-19 on companies and economies, meaning the list of potential fallen angels is now growing.

For now though, both the sellside and buyside within the European high-yield bond segment remain sanguine about this situation, with some investors keen to pick up any new names on offer. What's more, few players appear to be concerned that a slew of fallen angels could overwhelm the market — although some analysts do warn of indigestion arising from credit downgrades in certain sectors.

Note that a fallen angel is a company whose credit rating has been downgraded to sub-investment grade. The majority of its ratings (typically two, from the three major agencies, Fitch, Moody’s, and S&P) have to be in this category to be designated a fallen angel, but if the company is only rated by one agency, then that is sufficient.

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“We don’t see fallen angels swamping the market, though it depends on what type of economic recovery we get,” comments a head of a high-yield syndicate. “If we get a 'V'- or 'I'-shaped recovery then I don’t think investment-grade accounts will sell out. But if we get a 'U'- or 'W'-shaped recovery, then names might bounce in, but bounce out again.”

“If a company is downgraded to BB+, but still has one IG rating, then as we have already seen with Syngenta, there is a lot of appetite for these types of names,” says another head of high-yield. “Syngenta sold €500 million [of high-yield bonds] and then tapped [the market] for another €100 million.”

“On the whole you would think fallen angels would improve the credit quality of high-yield,” notes a fund manager. “I suppose the concern though is that while 'triple-B flat' rated companies are mostly telcos and utilities, the 'triple-B minus' credits are auto-related and basic industries. But these are still large capital structures, with greater liquidity and so can ride out the storm. They have high leverage, but we are used to that.”

May sees a number of fallen angels enter high-yield indexes, the biggest of which is Ford Motor Co., with $85.7 billion of bonds outstanding — of which roughly €13.5 billion is euro-denominated, spread between 2020 and 2025 maturities, according to Refinitiv.

Ford is a good example of why high-yield accounts, by and large, are comfortable with many fallen angels. “Too big to fail” is the mantra often used by the buysiders to describe such companies, and certainly the Fed's decision to buy fallen angels has added huge technical support to a name such as Ford.

That's why the borrower's longest sizable euro maturity — the 1.355% notes due 2025 — having initially fallen from 98.5 before the COVID-19 crisis to a low of 60.275 on March 24, has since bounced back to 81.6. Ten points of that rally came on April 9, when the Fed announced it would buy fallen angels — thereby highlighting the impact that central bank action has had.

Danger zone
This name, though, also demonstrates the danger presented by fallen angels, as Ford's downgrade to speculative-grade status came on March 25, with the bonds having sold off to their lows in the lead up to this (though the impact of COVID-19 will have played a significant part), highlighting that names on the verge of high-yield status can weaken in secondary as IG accounts sell out.

As analysts at BofA wrote in a report on April 30, titled Credit Strategy — Europe: Fallen Angels the names to watch: “Of particular concern for investors is the price action of Fallen Angels around downgrades. While far from the Lehman highs, we find that the current spread gap between BBBs and BBs is still an elevated 230bp. For some of our Fallen Angel candidates, therefore, this points to eventual price drops of up to 6pts, we think.”

The flipside to that dynamic is it can lead to attractive entry points for high-yield. Moreover, accounts say that in the current environment, fallen angels offer other qualities that might appeal to investors. “In a recessionary environment you want to be out of the smaller cyclical credits,” suggests a portfolio manager. “Bigger is better as they have more liquidity and more assets they can sell to raise liquidity, while they are more likely to receive government subsidies.”

That description though is not true of all fallen angels, and fund managers are aware of names that could remain in the double-B space. What they do not want is a credit such as DIA, which on April 28 was downgraded to Caa2, having been IG-rated in October 2018. “Fallen angels have big cap stacks and so more liquidity, and that is a plus,” says another fund manager. “But in Europe the companies are not that great. I worry about retail and airlines, for example. You also have a very distorted market from IG, where spreads have been pushed too low.”

Retail and airlines account for a significant number of the list of potential fallen angels. Moreover, while high-yield participants might not be that concerned by fallen angels swamping the market, the auto sector alone could cause some issues. “The European HY market will potentially face indigestion caused by Fallen Angels. Note that BBB-rated [euro] debt in the auto segment accounts for €92.8bn alone, which is almost 30% of the entire HY universe,” wrote BofA analysts in a note early in April, titled Credit Strategy — Europe: Auto fallen angels: driving off of the cliff? In the April 30 report though, the BofA analysts note that “In total, we see around €25bn of high-grade debt being impacted. The lion's share of this is made up of auto debt, but media, consumers and capital goods also populate our list, given their consumer-centric nature.”

There are, however, forecasts that much more debt than this will be impacted. “We revise up our fallen angel target to €100bn, or 4.3% of investment grade notional ... The BBB market has grown by almost six times during this cycle, to €1.1tn from €190bn. Further, this includes €226bn of BBB- rated bonds,” noted analysts at J.P. Morgan back in March, in a piece titled Fall from Grace II.

Others say there is still some way to go before the market is asked to take on as much fallen angel paper as in previous crises, but note the potential numbers are still eye-watering.

“There has also been more than €30bn and £3.5bn of EUR and GBP fallen angels, respectively,” wrote Deutsche Bank analysts in a report at the end of March, titled Accelerating fallen angels ... but is this just the beginning? “For the proportion of BBB downgrades for 2020 to reach the GFC level for non-financials we would need to see a further €64-76bn of EUR bonds downgraded to HY by the end of the year. In order to get toward the previous peak levels in excess of 15% of BBBs then we would need to see another €150bn of EUR BBBs [downgraded by year-end]. This could add more than 45% to EUR HY,” adds the DB report.

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Technical dynamics
While the numbers could be daunting, the technical dynamics remain supportive. “There is some forced selling when a name leaves the IG index, but accounts that can hold double-Bs will keep them, so we do not expect price action to be too disorderly,” claims another portfolio manager. “Many high-yield managers don’t want to be underweight the index, so there will be a good bid for paper, while IG accounts will not be rushed into selling, and so many hold double-Bs that if they think will come back to IG, they will sit on.”

However this situation pans out, it's worth remembering that to date fallen angels have been absorbed by high-yield, while participants agree there is a potential technical on the horizon that would dramatically shift the market, whatever side of the debate they take. “The Fed buying fallen angels was a game changer, not just for those names but the whole market,” says a buysider. “We expect the ECB to do the same, and that would be huge.”

Luke Millar is senior news desk manager at LCD, Europe.

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