The perfect storm of the coronavirus pandemic and oil-supply glut has driven the volume of fallen angels – or issuers downgraded to high-yield status – to new highs. The risk premium for fallen angels is most visible in BBB-rated credit spreads.
The heightened risk that BBB-rated instruments will be downgraded to high-yield status means that many investment-grade investors will reduce their exposure to these credits. Fallen angels will also be subject to forced selling by investment-grade accounts that are no longer able to hold them.
There is also concern that the wave of downgrades will cause indigestion in the BB-rated market – something that can be seen when looking at the relative performance of BB and BBB-rated credits.
These technical moves often present opportunities for flexible credit investors that allocate across the capital structure of global issuers. Since the sell-off began, BBB-rated credits in Europe have materially outperformed those in the US (see figure 1).
Figure 1. Relative performance of US and European BBB-rated credit
Source: ICE Bond Indices, as at April 2020.
This is partly because the European Central Bank’s debt-buying programme provides more support for the BBB-rated market, while its exclusion of fallen angels provides more incentives for issuers to retain their investment-grade status.
The dominant sectors in the European market – utilities, telecommunications and banking – also make the region more favourable in this environment. Telecommunications issuers are less affected by the coronavirus pandemic, while banks are seen as the solution to the crisis. Meanwhile, energy – the most exposed sector – makes up a far smaller share of the index than in the US.
Finally, the European credit market has a slightly higher average credit rating than its US counterpart. On a composite rating basis, the European market has 5% more credits rated BBB+ and 5% fewer rated BBB- and BB+.
The Federal Reserve’s announcement that it will support fallen angels means that the European market’s premium has fallen recently. But given structural differences between the two markets, we believe that it is here to stay. Meanwhile, the market offers opportunities for credit investors that are able to take a top-down look at opportunities throughout the multi-layered capital structures of global issuers.