Fixed-income markets have unwound at a record pace in recent months, as the coronavirus crisis has caused credit spreads to surge and earnings forecasts to plummet. The shakeout has brought BBB-rated credits – the lowest tier of investment grade – into sharp focus.
The BBB-rated segment of the market has grown at a rapid pace over the past decade and is set to expand further as the current crisis causes downgrades to increase. Anxiety about the pickup in fallen angels – companies downgraded to high-yield status – means that the difference in the spreads of BBB and BB-rated credits has widened to the greatest level in a decade (see figure 1).
Figure 1. Difference in spread between BB and BBB-rated credits
Source: ICE Bond Indices, as at April 2020.
These weaker investment-grade credits tend to be those suffering from secular industry changes – such as auto-makers and energy firms – or ones that have chosen to pursue mergers and acquisitions and reward shareholders with dividends and buybacks (many consumer companies fall into this category).
Last week, the Federal Reserve announced it would extend its original plan to stabilise the dislocated front end of the investment-grade market to buying fallen angels, which helped to correct the relationship between BBB and BB-rated credits.
Much of the market stress surrounding fallen angels has eased. Central banks are focused on supporting large companies that tend to be major employers, while ratings agencies have been much more proactive than during previous crises. In addition, most of the obvious contenders have already been downgraded – or will be over the next month, as earnings season unfolds.
Moreover, in some of the more challenging sectors such as energy, there has already been substantial repricing, with some long-end bonds of former investment-grade companies trading in the 40s-50s.
As earnings season progresses, it will become clear how challenging the current environment is for lower-rated companies. There will continue to be considerable demand for fallen angels, with non-cyclical and underrepresented sectors initially the most popular. Attention should then turn to the more cyclical industries, as investors compare issuers to existing names within the high-yield universe.
In the medium term, asset allocators will look favourably on the growth of the high-yield index, which has stagnated at about $2trn over the past five years. Moreover, the influx of fallen angels has helped improve the average credit quality of the high-yield index – which is one of the reasons we think the asset class is particularly attractive at the moment (read more about this in our recent piece, ‘When coupons are king: the case for global high-yield credit’).