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Fallen angels radar: a dynamic quarter for opportunities
Ashton Parker
Head of Credit Research
Anando Maitra, PhD, CFA
Head of Systematic Research and Portfolio Manager
key takeaways.
Ratings actions made for a busy quarter that brought solid supply to the fallen-angels universe – we chart the bonds in question and consider the stakes going forward
How have fallen angel price discounts evolved historically? Our ‘Top of mind’ section responds to this investor question
Our outlook discusses the general credit backdrop and focuses on sectors potentially creating more fallen angels in the future
Bond by bond, this issue of Fallen angels radar explores how the universe has changed as a result of companies being downgraded from investment-grade (IG) ratings. We discuss the prospects for recovery as well as opportunities outside the index that are not accessible with passive approaches. Plus, we weigh in on the best question asked of us by investors this quarter.
How has the fallen-angels universe changed?
It was a dynamic quarter for the fallen-angels universe, with several new entrants and a high-profile downgrade in the UK water utilities space that ultimately led to its exit from the index after just two months1. Below, we chronicle progression in the universe and credit-related opportunities that have arisen.
Thames Water2
Cut to BB by S&P and Ba1 by Moody’s in July
Class A debt cut to CCC+ and class B debt to CCC- by S&P in September
Cut to Caa1 by Moody’s in September
Rationale for ratings action
The private British utility is responsible for the water supply and waste water treatment in most of Greater London and across other parts of England.
The initial downgrades reflected challenging operating conditions as well as liquidity concerns. Numerous unconfirmed options were touted, including possible failure and nationalisation.
The September downgrades to Caa1/CCC+ followed the company saying it only had sufficient liquidity to cover its needs until end-December 2024 – much earlier than the May 2025 timeline it previously envisaged – thus making some form of restructuring increasingly likely.
Moody’s said the inability to attract new equity funding may “ultimately lead to a creditor-led debt restructuring or one that is imposed as part of a special administration process.”
Longer term view
While the rapid deterioration in ratings was disappointing, it was not surprising and had led us to adopt a nuanced investment approach when the company was initially downgraded to BB in July 2024. Our view at the time was that some form of debt exchange could be necessary and that bondholders might be required to take a ‘haircut’ on their bonds. But, ultimately, we expected the various stakeholders – including banks, bondholders, equity owners, the UK government and the regulator OFWAT – would ensure the company’s survival.
This remains our view, although the timescale for a successful resolution is now clearly shorter, which increases the level of possible jeopardy.Our fundamental analysts therefore calculated the likely recovery level on the bonds, and we invested at prices around or below that level. This active approach ensured we would still benefit from upside in a recovery but would face limited losses in a distressed situation. Following the downgrades in September, bond prices have converged towards our recovery valuation, with the higher priced bonds we did not buy materially under-performing. A combination of active management and sound fundamental analysis helped us manage a tricky situation.
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Carnival Cruise Line2
First ratings assigned by Fitch in August
Long-term issuer default rating of BB
Secured notes of BBB-
Rationale for ratings action
The international cruise line company’s rating meant that Carnival’s secured notes (7.875% due 06/01/2027) now have two IG ratings (including a BBB- from S&P) and one high-yield rating (Ba1 from Moody’s). The notes left the universe, though the outstanding amount was small at just USD 192 million.
Longer term view
We continue to see value in the unsecured notes from the company, which we expect to return to IG over the next few years due to the strength in demand for cruise holidays and improving financial metrics.
VF Corp2
Cut to Ba1 by Moody’s in September
Rationale for ratings action
The American apparel and footwear company was downgraded following an extended period of poor operational performance, mainly driven by the weak performance of its key brands, such as Vans, and the generally soft consumer backdrop.
Longer term view
We have been anticipating this action for some time and expect S&P to follow suit, perhaps when the company’s Q2 results are released on 30 October.
A recent USD 1.5 billion asset disposal has supported liquidity and given the company additional time to implement a turnaround plan. Still, we are concerned that management has been more successful at cutting costs than reinvigorating its key brands, which are a critical driver of performance in this competitive sector.
OCI NV2
Cut to Ba1 by Moody’s in September
Rationale for ratings action
The European fertiliser and chemical producer was downgraded in anticipation of a material reduction in the company’s scale after it sold approximately two thirds of the business for USD 9.7bn.
Some USD 3.4bn of the proceeds are expected to be returned to shareholders, and various bank facilities and its 2025 bond are being repaid. This leaves the business with about USD 4 bn in cash on the balance sheet at the time of writing.
Longer term view
It is unclear to us how the remaining USD 4 bn in cash will be deployed at this stage, and we hope to get further colour when the company reports its Q3 earnings.
For this company, the rating depends on how the cash on the balance sheet is deployed and management’s financial policy going forward, which we believe could support a rating in the Ba range.
Mobico Group plc2
Cut two notches to Ba2 by Moody’s in September
Rationale for ratings action
Moody’s downgrade of the British public transport company was driven by the agency expecting only a gradual and limited improvement in Mobico’s weak financial metrics over the near term, as free cash flow will remain negative given high capex related to its restructuring plan.
While the disposal of the North American School business could reduce leverage, it will also reduce the company’s scale and diversity, and therefore weaken its business profile beyond that expected of an IG company.
Longer term view
We found Moody’s downgrade a little harsh. The company, formerly known as National Express, has a clear plan to deleverage through the sale of its North America school bus business, which we expect to occur in 2025 and should support ratings, in our view. We expect Fitch to maintain its BBB- IG rating.
Interestingly, the Moody’s downgrade triggered a 125 bps coupon step-up in the GBP 2.375% bonds due 11/20/2028 that led to an increase in price of the bond. In contrast, the EUR 4.875% notes due 09/26/31 without a coupon step behaved more normally.
In this section, we answer the best question we have received over the past quarter about investing in fallen angels.
Question:
Is the average discount to par of fallen angels at the time of downgrade over the past three years the same as the universe’s long-term history?
Answer:
Yes, for the fallen angels that are from stressed sectors (such as real estate) or in some idiosyncratic cases. In the real-estate sector, we have seen issues that were trading at 20-30 points below similarly rated issuers3, creating a strong source of alpha potential.
However the supply of such fallen angels has been relatively limited in this period compared to previous episodes such as during the COVID-19 pandemic, the Global Financial Crisis, the commodities crisis etc.
The average price of new fallen angels continues to be in the 80-85 price range over the past three years consistent with 20-year averages, as shown in figure 1.
FIG 1. Average price of fallen angels at downgrade4
What’s the outlook for fallen angels?
The current interest rate cutting cycle continues to support fixed-income assets after the Federal Reserve loosened policy by 50 bps in September. Meanwhile, the direction of travel for rates in the eurozone and UK appears inevitably lower. We acknowledge a number of rate cuts are already priced into the market, particularly within IG credit, but retain a modest preference for duration. While there is some stress across sectors, notably automotive, we do not anticipate a material economic slowdown.
Therefore, we see more value within higher quality high-yield credit where we can benefit from greater spreads and potential returns. We consider the current environment to be supportive of fallen angels, which generally have longer duration than native high-yield bonds and are of high quality generally in the BB range.
By sector, the recovery in real estate since the end of last year continues, albeit at a slower pace. We believe this sector might provide more fallen angels. While interest rates have peaked, which will stabilise valuations, refinancing costs remain elevated and interest cover – a key credit metric – could soften. Weakness within the consumer-cyclical sectors is beginning to appear, particularly within retail and automotive with a number of new fallen angels coming from the former already this year. Automotives have seen an increase in profit warnings recently linked to China and the slow take-up (and high cost) of electric vehicles – while there has been negative rating action, no new fallen angels have arisen yet.
click here to learn more about our Fallen Angels Recovery strategy
4 sources
view sources.
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1 The index refers to the Bloomberg Global Corporate ex-EM Fallen Angels 3% Issuer Capped. 2 Fallen angels are driven by the bond rating being downgraded rather than the issuer rating. In this paper, we assume that the two ratings are the same, unless otherwise specified. Credit ratings are subject to change. 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. Important information on case studies: 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 of 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 Fund'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 Fund now or in the future. 3 Yields are subject to change and can vary over time. Past performance is not an indicator of future results. 4 Source: LOIM. For illustrative purposes only. As at 17 October 2024. Past performance is not an indicator of future results.
important information.
For professional investors use only
This document is a Corporate Communication for Professional Investors only and is not a marketing communication related to a fund, an investment product or investment services in your country. This document is not intended to provide investment, tax, accounting, professional or legal advice.
