Credit market downgrades are coming – and that spells opportunity
Downgrades from investment grade to high yield, often referred to as ‘fallen angels’, have been rising. Counterintuitively, this could present one of the year’s most notable fixed income opportunities.
Credit rating downgrades were scarce last year, when only six US issuers transitioned from investment grade to high yield, a record low volume of $7bn<sup<[1]. We anticipated a sharp turnaround, projecting a reversion to the annual average run-rate of $50bn. We were not alone; the median investment bank forecast is $45bn for 2025<sup<[2].
It did not take long for downgrades to materialise. In February, there were two of the three largest downgrades since the pandemic: the downgrades of Nissan and Celanese transferred $16bn to high yield indices, amounting to more than double last year’s total volume.
More downgrades could be on the way
We think a lot more downgrades could be on the way. Historically, 80% of fallen angels have been downgraded from BBB-, a rating category that currently represents a $700bn<sup<[3] market in the US. A closer look at this segment reveals warning signs.
Interest coverage ratios have started to diverge between mid-BBB issuers and their BBB- counterparts. Approximately $200bn of BBB- issuers already carry a high yield rating from one of the rating agencies, and a similar amount have two negative outlooks from them<sup<[4]. We estimate around $325bn are priced at wider credit spreads than comparable BB-rated high yield bonds.
We think this leaves several issuers potentially on the brink of a downgrade, and an increasingly uncertain economic outlook could cause rating agencies to pull the trigger on any number of them. Although this may seem like a sign of bad market health, this development could be an opportunity for investors.
Investors can turn downgrades to their advantage
When large bond issuers are downgraded from investment grade to high yield, it can trigger predictable, and potentially exploitable, volatility.
In the US, passive investment grade corporate bond strategies manage $1.5trn of assets4. When any of their holdings transition from investment grade to high yield, they typically become ‘forced sellers’ of the bonds as these strategies seek to track their benchmarks. This has often resulted in waves of simultaneous selling.
This can depress bond valuations to potentially unjustified levels, presenting active investors with opportunities on which to capitalise.
We analysed every US bond that was downgraded from investment grade to high yield since the launch of the Bloomberg US HY Fallen Angel 3% Issuer Capped Index. On average, we found that these bonds suffered 10% losses over the six months up to their index transition, and then recovered by 11% on average over the subsequent 12 months (see Figure 1).
The takeaway is that buying bonds immediately upon a downgrade to high yield has historically been a winning strategy. Ahead of a potential cascade of downgrades, it could be worth positioning to catch them. We think the opportunity is enhanced by a muted default outlook, given our view of fundamentals and structural high yield market changes.
A dedicated fallen angel strategy may be the best way to exploit the opportunity
In our view, a flexible active strategy that offers a manager the latitude to retain issuers in the event of a downgrade can help investors retain value in the bonds.
However, to make the most of the opportunity we believe a dedicated allocation to fallen angels is worth considering. The most effective way to do so, in our view, is via a systematic approach that aims to minimise trading costs, invest broadly across the market and target outperformance.
By Syed Zamil, Senior Investment Strategist
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