Fallen angel risk – or the possibility that bonds will be downgraded to junk status – has dominated the headlines over the past two years. And for good reason: the BBB-rated segment of the market (the lowest tier of investment grade) has grown from less than $2trn in 2010 to nearly $5.5trn in 2020 (see figure 1).
Figure 1. The size of the BBB-rated universe has soared over the past decade
Source: Federated Hermes, ICE bond indices, as at February 2020.
There are several reasons for this. Interest rates at record lows encouraged companies to increase their share of debt financing, while a stronger macroeconomic environment in the run-up to the summer of 2018 led to a growing number of rising stars. In addition, quantitative easing and the growth of reverse Yankees mean the European BBB-rated market has quadrupled to €1.2tn over the past decade.
The global high-yield market has also stagnated since 2015. Financing was redirected to the leveraged-loan market, which benefited from the recovery in collaterised-loan obligations and the move into floating-rate products by retail clients spooked by rising interest rates. This meant the US ten-year treasury yield rose from 1.35% in 2016 to 3.25% in 2018.
This year has seen a number of companies downgraded. While it seems that pressure is building up in certain parts of the market, the high-yield space has shrunk by more than $100bn over the past five years. With nearly all BB-rated bonds trading above call, these downgrades could be seen as a blessing rather than a curse.
The risk of a recession is low, and the majority of companies are wary of forsaking their investment-grade ratings in exchange for higher shareholder returns. This means that there should be just enough fallen angels in 2020 to reinject some convexity into the BB-rated market and introduce more liquid capital structures with multiple access points.
Importantly, a pickup in fallen angels should also increase the size of the high-yield market – something that is greatly needed, given that macroeconomic uncertainty has lowered demand for equities and a silver-tsunami reallocation to fixed income is well underway.