investment viewpoints
Fallen angels radar: optimising recovery potential
In this third issue of Fallen angels radar, we monitor developments in the fallen-angels universe and track the progression of credit ratings. Which corporate bond issues have lost their investment-grade (IG) status to join the segment? What other investment opportunities and risks have arisen that only an active approach can identify?
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Charting changes in the fallen-angels space
Following marked expansion of the index last quarter, new opportunities in fallen angels took the form of two downgrades to high yield this quarter. Meanwhile, our active approach identified fresh investment opportunities as well as risks in the space. Below, we chronicle developments in the universe1.
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SAUR
Rationale for downgrade
The company is an integrated water and wastewater treatment and distribution operator in France and the Iberian peninsula.
The ratings moves follow weaker than expected performance in 2023 and slower than expected deleveraging due to a lower than anticipated 2024 tariff revision in the Water France operations.
Longer-term view
SAUR is owned by Swedish Investment Group, EQT Infrastructure, and a consortium including global infrastructure fund manager, DIF Capital Partners and Dutch pension fund, PGGM.
The shareholders are long-term investors and have built a track record of supporting the business.
We note that about 75% of revenues come from long-term contracts with fixed tariffs adjusted for inflation, making revenues visibility high and meaning the business should deleverage slowly over the next few years, primarily from EBITDA growth.
The company’s liquidity position is sound with about EUR 300 million in cash and an undrawn EUR 200 mn revolving credit facility through to March 2026. In the near term, SAUR needs to address approximately EUR 750 mn worth of refinancing coming due in 2025.
While we expect S&P to downgrade SAUR in due course, we believe it could operate as a BB rated entity presently.
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CPI property group
Rationale for downgrade
CPI Property owns assets throughout central and eastern Europe and Germany. The downgrade – following the company’s limited success in deleveraging and in anticipation of continued pressure on financial metrics – came as something of a surprise to the market.
CPI had been working hard to sell assets, raise liquidity, simplify the company’s structure and improve governance.
Longer-term view
CPI is not a constituent of the fallen angel index, which excludes emerging market issuers. However, our credit analysts have followed this name, as well as the sector as a whole, closely for a number of years through careful research. In our view, S&P’s action seems a little severe.
We believe the company could be able to operate as a BB entity going forward.
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Ceconomy
Rationale for refinancing
Ceconomy took advantage of recent credit spread tightening and strong operational performance to refinance its debt in the shape of a EUR 500 million sustainability-linked bond.
The bond’s interest rate is linked to the company reducing indirect greenhouse gases (Scope 3.11).
Longer-term view
We believe the refinancing was a prudent move and we were impressed with Ceconomy’s conservative financial policy – including low levels of leverage and robust liquidity.
The retailer’s strategy should deliver improved margins and cash flows in coming quarters, in our view.
Source: LOIM. For illustrative purposes only. Credit ratings are subject to change. 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.
What’s the outlook for fallen angels?
We continue to believe volatility could pick up, and we expect somewhat steeper yield curves. This should mainly impact the lowest-rated part of the credit spectrum, notably corporate issuers rated B and below. As such, we prefer to underweight the lower rungs of high-yield in favour of higher quality exposure such as fallen angels rated around BB.
The strength of the recovery in real estate since the end of last year has been something of a surprise. However, we still expect this sector to provide a number of new fallen angels this year as higher interest rates continue to impact valuations and financial metrics.
Going forward, the impact of higher interest rates and lower disposable incomes could adversely impact some companies’ credit quality, particularly those in the consumer cyclical sectors such as automotive, leisure excluding cruise lines and airlines, in our view.
However, new fallen angels are not currently concentrated within specific sectors but driven by company specific actions or challenges. Such idiosyncratic risk makes fundamental analysis prior to investment in new fallen angels even more critical.
Actively seeking the best recovery potential in a quantamental approach
Passive fallen-angels strategies tend to invest indiscriminately into fallen angels – including falling knives which deteriorate further in credit quality and price. This can negatively impact both performance and risk. We believe that such exchange-traded funds fail to differentiate between the best fallen angels – those with the greatest recovery potential and expected stable ratings in the BB area – and the rest. Only active management can help avoid falling knives, in our view.
Our Fallen Angels Recovery strategy employs both fundamental and quantitative tilts in what we call a ‘quantamental’ approach. The fundamental aspect includes credit analysis that takes into account a borrower’s financial profile and its business profile.
- Financial profile: What is the company’s profitability? How strong and stable is the company’s cash generation and how well can it service its debt?
- Business profile: What are the risks to company’s business? How attractive is its industry? How is the company positioned within the industry?
This 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.
Over the past quarter, our active approach also helped identify potential in specific areas linked to bond refinancing and borrowers not included in the index. Such prospects can present a rich seam of opportunity, provided that bottom-up credit analysis is applied to ensure strong company fundamentals will keep such borrowers in the top end of the HY ratings area.
Continuous monitoring
Sometimes, a falling knife is not immediately apparent at the time of downgrade as a company’s situation changes – this means it can take time to identify a falling knife and makes an active approach even more pivotal to mitigating risk. We continuously monitor the performance of the fallen angels in our portfolio to ensure they are delivering what we expect – and stand ready to take prompt action should they not.
For instance, at the time of its July 2022 downgrade, we initially viewed Atos2, the French IT company, as a fallen angel because it had a reasonable turnaround plan and sufficient liquidity to function while management implemented the programme. Over time, however, we realised that management was failing to deliver. Thus, we identified Atos as a falling knife and steadily reduced our exposure to exit the position3. In contrast, since the company remains in the fallen-angels index, a passive strategy would have maintained its allocation and incurred larger losses.
Quantitative heuristics for additional alpha
In the quantitative aspect of our quantamental approach, we use systematic tilts to capture relative value using a data-driven method. This involves identifying three heuristics from historical patterns that aim to generate additional alpha:
- New fallen angels tend to significantly outperform aged fallen angels4
- BB and better rated fallen angels usually have superior risk-adjusted returns than lower rated bonds4
- Fallen angels that exhibit price over-reactions at the time of downgrade are inclined to outperform4
These heuristics tend to generate greater outperformance in volatile periods when there is an elevated supply of new fallen angels. Despite the benign environment for fallen angels supply since 2021, there have been multiple opportunities to generate alpha in a systematic manner. In particular, the dislocation of the real-estate sector resulted in multiple opportunities to capture price over-reactions in 2022 and early 2023. These dislocations subsequently reversed in 2023-24, which an active strategy could then be adjusted for.
We believe a quantamental approach can help generate significant alpha not just in the fallen-angels space but also in the broader fixed-income suite of products, such as Crossover or corporate bonds rated BBB to BB.
We have been managing Crossover portfolios rated BBB to BB since 2010 and offer a dedicated skillset in this segment. Our fallen-angels team of five specialists is supported by strong research and risk capabilities, including 13 credit analysts, a sustainability team providing forward-looking analysis on aspects such as climate-risk, and three independent risk professionals.
Sources
important information.
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