fixed income

Catching falling angels, avoiding falling knives

January 12, 2022

Ashton Parker

Head of Credit Research

Need to know

•   Fallen angels – bonds which have been downgraded from investment grade to high yield – could offer investors attractive opportunities due to valuation dislocations.
•   Still, investing in fallen angels also involves the risk of the bonds becoming ‘falling knives’ that continue to drop in credit quality and therefore price.
•   Our fallen angels strategy applies rigorous credit analysis from the bottom up to ensure we avoid those falling knives and invest only in those fallen angels that should benefit from ratings recovery and a reversal of price pressures. We illustrate our approach with fallen angels case studies on Ford and Seagate, and a falling knife case study on Washington Prime¹.

Investing in fallen angels enables investors to capture return opportunities generated when these bonds are downgraded from investment grade to high yield. Valuation dislocations arise due to forced selling that has historically caused fallen angels to be severely undervalued relative to their rating peers in the BB bucket, and to show persistently superior risk-adjusted returns versus other corporate credit segments over the last 16 years².

That said, investing in fallen angels comes with hazards that necessitate an active approach to credit analysis. “Falling knives” are fallen angels that continue to deteriorate in credit quality (and price) through the rating categories and potentially towards default. As such, a rigorous bottom-up analysis is required.

How does our strategy capture well-suited fallen angels while avoiding potential falling knives? We present examples to illustrate how our bottom-up credit analysis differentiates between the two. Our active approach aims to invest in those fallen angels whose financial position may have deteriorated but whose business profile appears nonetheless sound. In essence, this means the right fallen angels will potentially benefit from ratings recovery and a reversal of price pressures, whereas the falling knives will not, instead risking further downgrades and downward price pressure.

Assessing financial and business profiles

Our credit analysis involves in-depth consideration of:

The borrower’s financial profile: How strong and stable is the company’s cash generation? How well can it service its debt (by looking at leverage³ metrics such as debt to EBITDA and interest coverage ratios)? What is the company’s profitability? What is its financial policy? Does it target specific financial metrics?

Companies are typically downgraded to high yield because their financial profile has become too stretched to merit an investment grade rating. Yet a company’s financial profile is often based on historic performance, rather than being more forward looking. For that, it’s key to look at the company’s business model.
The borrower’s business profile: What are the risks to company’s business? How attractive is its industry? How is the company positioned within the industry? Here, we consider the company’s strategy and its technical resources and management team: what is its track record of delivering against targets, or of integrating other companies? How is it adjusting its business model to meet new market dynamics such as low carbon, competitive developments or technology?

This level of analysis enables us to determine if the business model of the company will permit it to thrive in future, potentially improving its financial position and leading to ratings recovery.

Analysis in action

Let’s see this credit analysis in action with case studies⁴ from Ford, Seagate and Washington Prime⁵.

Falling knife: Washington Prime

Washington Prime Group is a real-estate investment trust focused on structurally challenged, mid-tier shopping malls in the US. The company was downgraded in October 2019 to BB. Its financial performance steadily deteriorated thereafter, leading to further ratings downgrades and culminating in the company defaulting in March 2021.

Our analysis led us to exit our position in December 2019⁶ after concluding that the company’s business model was challenged and that its revenues faced a fundamental decline. Firstly, shoppers were increasingly moving towards online purchases, sapping demand for retail space. Secondly, the live shopping experience was increasingly oriented towards prime shopping centres, whereas Washington Prime is specialised in secondary centres. This meant the company’s business model was faced with fewer shoppers, leading to weak operating performance from its mall portfolio. It also lacked the resources to withstand further shocks and suffered from high leverage.

Figure 1 illustrates how quickly a bond price can fall when faced with such challenges, and how important careful bottom up analysis is to preventing exposure to such risks.

Figure 1. Washington Prime 5.95% bond due August 2024 (price)

Source: Bloomberg. For illustrative purposes. Past performance is not a guarantee of future results.

Fallen angel: Ford

Ford Motor, one of the oldest and most well-known automotive companies in the world, was downgraded to high yield at the peak of the COVID-19 crisis in March 2020.⁷ The downgrade occurred amid the largest supply of fallen angels in any historical month and coincided with extreme fund outflows. Bond spreads overshot the average BB universe by over 500bps.

There was a strong reversion in Ford soon after, however. The initial recovery was liquidity related, with the actions of the US Federal Reserve driving prices. Thereafter, the more regular recovery in Ford showed the long-term tendency of credit over-reactions to reverse, as well as the company’s solid business profile.

The downgrade reflected the operating and market challenges facing Ford while it was undertaking an extensive restructuring plan, and cash flow and profitability were weak. Yet although the company’s financial metrics deteriorated, it remained a large player in a market where demand for cars was resilient. As such, its business profile showed positive signs.

For instance, the company is a large-scale manufacturer with a strong position in the profitable truck segment; it is executing on its margin recovery plan and shifts in drivetrain; and it has invested in developing electric vehicles. Our analysis showed a strong credit performance, prudent risk management and a large capital structure in its captive finance business. We determined Ford had the strength and size to withstand COVID-19 challenges, especially as the pandemic put demand on hold for cars rather than eliminating it. While the company faces the same supply chain issues as the rest of its industry, there is no sign of the business or industry being in structural decline.

This analysis led us to conclude that the company’s business model is not broken - especially as it had previously come back from its 2005 downgrade from IG to HY – and is less likely to suffer further sharp price falls.

Figure 2. Ford bond 3.664% due 09/05/2024 (price)

Source: Bloomberg. For illustrative purposes. Past performance is not a guarantee of future results.

Fallen angel: Seagate

US data storage company, Seagate Technology, issued a USD 1 bn bond to fund share buybacks in late 2020 and was downgraded to BB as a result. The company decided to pay shareholders a dividend, effectively preferring equity holders to debt holders, and chose to weaken its financial metrics as a result.

The key issue for our analysis was the company choosing to pay this dividend rather than being acted on by outside forces. The active choice does not mean Seagate will suffer further downgrades, especially as we found it was comfortably able to fund the business going forward. Despite facing downward secular trends in legacy hard disk drive markets and (inevitable) industry cyclicality, our analysis found the company has a strong track record of generating robust free cash flow. As such we determined it is a high-quality, high-BB credit with gross leverage in a 2x-3x range and ample liquidity.

Figure 3. Seagate bond 4.125% due Jan 2031 (price)

Source: Bloomberg. For illustrative purposes. Past performance is not a guarantee of future results.

Catching fallen angels necessarily involves avoiding falling knives. Careful credit analysis of a borrower’s business prospects going forward can help differentiate between the two, ensuring investment in only those names with compelling recovery prospects.

To read the white paper on our fallen angels strategy, please click on the download button.

Sources

1 Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.

2 Past performance is not a guarantee of future returns.

3 Leverage measures borrowing relative to company earnings. Company leverage typically measures the ratio of a corporate’s debt relative to earnings (such as EBITDA).

4 The case studies provided in this document are for illustrative purposes only and do not purport to be recommendation of an investment in or a comprehensive statement of all the factors or considerations which may be relevant to an investment in, the referenced securities. The case studies have been selected to illustrate the investment process undertaken by the Manager in respect of a certain type of investment, but may not be representative of the strategy’s past or future portfolio of investments as a whole and it should be understood that the case studies of themselves will not be sufficient to give a clear and balanced view of the investment process undertaken by the Manager or of the composition of the investment portfolio of the strategy now or in the future.

5 Any reference to a specific company or fund does not constitute a recommendation to buy, sell, hold or directly invest in the company or funds. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the funds discussed in this document.

6 This illustrative case study refers to a historical example and analysis undertaken for a different strategy. The fallen angels recovery strategy was launched on 30 November 2021.

7 This was Ford’s second foray into fallen angel territory, having been downgraded from investment grade in 2005 as well.

important information.

For professional investor use only
This document is issued by Lombard Odier Asset Management (Europe) Limited, authorised and regulated by the Financial Conduct Authority (the “FCA”), and entered on the FCA register with registration number 515393.
Lombard Odier Investment Managers (“LOIM”) is a trade name.
This document is provided for information purposes only and does not constitute an offer or a recommendation to purchase or sell any security or service. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful. This material does not contain personalized recommendations or advice and is not intended to substitute any professional advice on investment in financial products. Before entering into any transaction, an investor should consider carefully the suitability of a transaction to his/her particular circumstances and, where necessary, obtain independent professional advice in respect of risks, as well as any legal, regulatory, credit, tax, and accounting consequences. This document is the property of LOIM and is addressed to its recipient exclusively for their personal use. It may not be reproduced (in whole or in part), transmitted, modified, or used for any other purpose without the prior written permission of LOIM. This material contains the opinions of LOIM, as at the date of issue.
Neither this document nor any copy thereof may be sent, taken into, or distributed in the United States of America, any of its territories or possessions or areas subject to its jurisdiction, or to or for the benefit of a United States Person. For this purpose, the term "United States Person" shall mean any citizen, national or resident of the United States of America, partnership organized or existing in any state, territory or possession of the United States of America, a corporation organized under the laws of the United States or of any state, territory or possession thereof, or any estate or trust that is subject to United States Federal income tax regardless of the source of its income.
Source of the figures: Unless otherwise stated, figures are prepared by LOIM.
Although certain information has been obtained from public sources believed to be reliable, without independent verification, we cannot guarantee its accuracy or the completeness of all information available from public sources.
Views and opinions expressed are for informational purposes only and do not constitute a recommendation by LOIM to buy, sell or hold any security. Views and opinions are current as of the date of this presentation and may be subject to change. They should not be construed as investment advice.
No part of this material may be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorised agent of the recipient, without Lombard Odier Asset Management (Europe) Limited prior consent. In the United Kingdom, this material is a marketing material and has been approved by Lombard Odier Asset Management (Europe) Limited which is authorized and regulated by the FCA. ©2022 Lombard Odier IM. All rights reserved.