The first quarter of this year saw bond issuers falling from investment grade to high yield at extraordinary rates. In Q1 51 companies became so-called fallen angels, compared to the whole of 2015 when there were 45, according to Moody’s figures. For the whole of 2009, the peak year in dollar terms for fallen angels, $143bn of debt was downgraded, compared to $140bn in the first quarter of this year alone.
Fallen angels might sound concerning, but they have outperformed high-yield indices by more than 2.5 per cent annualised over the five years to the end of 2015, according to the Bank of America Merrill Lynch Fallen Angel High Yield index.
Fundamental credit developments were the reason most issuers shifted in Q1 into the “crossover zone” – the rating categories closest to the border of investment and speculative grade, with 27 out of 34 moving for this reason. Six rating downgrades were related to sovereign rating changes and one was connected to M&A activity. At the end of March, the debt of “potential fallen angels”, those just above speculative grade with a negative outlook or on review for downgrade, was $234bn.
Carmignac head of credit Pierre Verlé says the “beauty of the fallen angel theme” is all the forced selling by the downgrade.
Verlé says the downgrade can also impact management priorities as companies work to return to investment grade to improve their access to credit. “One thing that is quite positive with fallen angels is that management is working for bondholders, and it doesn’t happen that often that management is working for bondholders rather than shareholders.”
Carmignac took positions in two fallen angels in Q1, with US miner Freeport McMoran and Murphy Oil, says Verlé. “This strategy is extremely opportunistic. Freeport had a broken balance sheet with way too much debt, a lot incurred to buy oil and gas at the peak. We had been monitoring this situation and we were getting ready to buy on downgrade,” he says, adding that the situation was similar for Murphy Oil.
The Carmignac team’s only fallen angel purchase last year was Petrobras, but was driven by different rationale. “That was more a political call than an investment driven by the credit strength of the issuer,” says Verlé.
But not everyone likes fallen angels, as head of investing at Axa Investment Management Adrian Lowcock explains. “Those are usually the sorts of bonds people try to avoid because there’s a fundamental problem with the underlying business. It depends where they settle in the high-yield market whether there’s an appetite among high-yield bond managers.”
Pimco portfolio manager for European high yield and bank loans Axel Potthof says because fallen angels are “often higher quality” than the average high-yield company and have a better chance of returning to investment grade the influx into markets could boost the long-term return potential of the overall high-yield sector. The fixed income manager predicts fallen angels could swell the high-yield market in Europe by 10 to 12 per cent this year. Reflecting this, in June, the Pimco Total Return fund will double its allowable allocation to junk bonds to 10 per cent in order to better tap into the high-yield market.
But Amundi strategy and economic research team strategist Sergio Bertoncini says the fallen angel story is very sector-specific. This is particularly the case in the US and emerging markets. In the US, 20 out of 26 fallen angels in Q1 were issued by energy or metal and mining companies. In the UK, Anglo American was the largest fallen angel, accounting for approximately $20bn of debt, which Moody’s attributed to the miner’s “bulk commodities portfolio, particularly in iron ore, amid low commodity prices”.
Bertoncini says there is a decoupling between the US and Europe when it comes to fallen angels. “Both on top-down and bottom-up factors Europe to us looks in better shape and in a better position than the US. In the US the cycle is more mature, credit metrics are more stretched and more leveraged and the Fed is clearly rising rather than cutting rates.”
Pothoff argues Europe offers more attractive opportunities in fallen angels this year because downgraded issuers are likely to be from more diversified sectors in Europe than the US, where the majority of downgrades are likely to be in the commodities sector.
Verlé says reduced impact to credit markets is something to bear in mind when picking a fallen ange. The team at Carmignac avoids issuers that require access to cheap credit for their survival. Verlé says: “In the case of Freeport or Murphy Oil they need the access to the market to refinance their existing debt, but they don’t need it on a permanent basis for their business model.” Banks would be a different story, he says.
M&G Investments’ retail fixed income team investment specialist Mario Eisenegger says Turkish financials, with $36bn-worth of bonds currently on negative outlook, were his main area for concern in Europe. He says: “Turkish financials in particular carry high volumes of US dollar debt, making them especially vulnerable to external factors.”
For the most part, M&G’s fixed income team does not favour the downgraded issuers. Eisenegger says: “Fallen angels normally indicate a deteriorating balance sheet. As a bond investor you favour companies that are in the process of deleveraging and can potentially benefit from rating upgrades.” However, he caveats that a fallen angel can be a source of “robust returns” if it’s been oversold and is offering attractive value.
With a lack of liquidity in the current bond market, Lowcock warns investors to avoid bond funds that may be at risk of becoming forced sellers. “While there’s a lot of issuance, there’s not a lot of trade going on. You don’t want to be in a situation where you’re a forced seller because effectively the buyer is going to determine the price.”
Lowcock lists Blackrock Global Fixed Income Opportunities and Artemis Strategic Bond fund “which can basically shop anywhere” as his picks for playing the bond market. Yellowtail Financial Planning managing director Dennis Hall says he would only be buying low duration bonds in the high-yield space, and avoiding index-linked funds.
“We’ve for a while steered clear of anything that is sub-investment grade or high yield,” he says. “There is a lot of potential for capital loss in those bonds, just because people are chasing yield and paying too much for yield and probably not doing the correct amount of analysis and research.”