fixed income
Fallen angels: stronger supply signals opportunity in high yield
Amid the toughest year in decades for fixed-income markets, a forward-looking view is more vital than ever for effective allocation across the asset class. Given the tougher conditions and likely rise in credit-rating downgrades ahead, we forecast a rise in the supply of fallen angels – investment-grade companies that have recently descended to high-yield status. This should lead to relative outperformance by this market segment, offering a prime opportunity to establish or increase exposure, in our view.
Need to know
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End of limbo for fallen-angel supply?
While the first half of 2022 has seen sell-offs at multi-decade highs in every corner of the fixed-income market, credit ratings have yet to crack. This is thanks to healthy corporate balance sheets following Covid-driven consolidation and prudence. As an indicator, this is somewhat backward looking, and sentiment suggests the market expects an inevitable deterioration in balance sheets in the coming months. Nevertheless, as things stand, a strong buffer exists against earnings headwinds from a credit perspective.
In fact, the recent ratings drift across European and US markets has been negative – i.e., there have been more upgrades than downgrades (see figure 1A). This has also translated to a negative net supply of fallen angels with fallen angels outnumbered by their opposites, the rising stars, as Covid-hit names have recovered following the easing of restrictions in many countries (see figure 1B).
FIG 1. Historical bond-rating upgrade/downgrade activity
Source: Bloomberg, LOIM calculations. As of May 31, 2022.
New wave of supply
As mentioned, fundamentals are widely expected to catch up with the deterioration in sentiment seen this year, sooner or later. With limited capital-markets access for companies, their cash buffers will run down as earnings are likely to be simultaneously hit by lower demand. This would ultimately reverse the trend in ratings and see downgrades take prominence. Some simple metrics support this view:
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Valuations
Markets are forward-looking discounting machines, with corporate spreads leading ratings action due to the lagging nature of fundamentals. As such, we view the year-to-date widening in credit spreads as a clear sign of impending downward ratings drift.
FIG 2. Historical spreads vs six-month ratings drift
Source: Bloomberg, LOIM calculations. Spreads as of 27 June 2022; ratings drift as of 31 May 2022.
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Financial conditions
The transmission of financial conditions into fundamentals, and hence ratings, takes some time. However, the recent tightening in financial conditions has been one of the sharpest on record, and as macroeconomic data show signs of weakening, the impact is now beginning to show on the demand side. Lower demand will also naturally lead to tighter lending standards, squeezed liquidity and a deteriorating ratings outlook.
FIG 3. Historical US financial and liquidity conditions vs ratings drift
Source: Bloomberg, LOIM Calculations as of 27 June 2022.
With these metrics considered, we can build a simple linear model to estimate ratings drift and the new supply of fallen angels for the coming 12 months. Our model clearly points towards a higher ratings drift, and consequently a sizable net supply of fallen angels (see figure 4).
FIG 4. Forecasted ratings drift and fallen angels net supply
Source: Bloomberg, LOIM Calculations as of 27 June 2022.
I’m loving fallen angels now
Why does this signify an appealing entry point for fallen angels? Because our research finds that excess returns for fallen angels – and their outperformance over high yield – peak in the period following a pick-up in supply (see figure 5). Consequently, we expect this pick-up in supply to presage a period of fallen angels outperformance over the broader high-yield index.
This period of outperformance can be attributed to the underperformance of bonds at the point of downgrade to fallen angels, as ratings-constrained investors are forced to sell. This phenomenon is evident in both fallen angels and high-yield indices. However, given the much smaller size of the fallen angels index, the weight of new supply has a substantially greater effect. As a result, the positive performance from their recovery has a greater impact on returns. To add a further layer of outperformance, at the same time, the greater breadth of the index offers the potential for heightened alpha as more opportunities arise.
FIG 5. Fallen angel supply relative to future performance
Source: Bloomberg, LOIM Calculations as of 13 June 2022. Past performance is not a guarantee of future results.
A high-quality fallen angels index
Given the threat of a recession in the not-so-distant future, investors may be concerned by the heightened credit risk in high yield. However, the current composition of the fallen angels index provides something of a cushion. The index presently has an average rating of BB+/BB, just over one notch below investment grade, which represents the highest credit quality in the 20 years of data available. It is almost two notches higher than the average rating for the high-yield index of BB-/B+, a quality differential which is also the largest observed in the last two decades.
The fallen angels index is therefore well positioned to benefit from an influx of new fallen angels, whilst maintaining a lower beta of current holdings relative to the broader high-yield index. While the higher concentration of the fallen angels index increases idiosyncratic risk, this can be mitigated through active credit research, rather than opting for a passive exposure, to identify fallen angels and not catch falling knives.
Fallen, but not from grace
We forecast a rise in downgrades and an increase in the supply of fallen angels, in line with heightened spreads and tighter financial conditions. Our analysis indicates this increase in fallen angel net supply is likely to lead to a period of structural outperformance by these issuers over their high-yield peers, as well as providing greater breadth for alpha potential within the asset class.
In addition, the quality differential between fallen angels and high yield is at a historical high, thereby providing a lower beta to a continued credit downturn. In conjunction with current attractive valuations and achievable yields of more than 6% (on a USD-hedged basis), we view this as an opportune time to tilt credit allocations towards fallen angels.
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