Central bank support has helped keep markets open for high yield issuance and avoided fire sale of downgraded assets.
Global fallen angel debt is on track to reach an all-time high of $640bn this year, according to S&P Global Ratings. The forecast figure dwarfs the previous record of $487bn in 2005.
A surge in fallen angel debt – investment grade bonds downgraded to high-yield or junk status – can fuel market volatility, as the bonds of the relegated company suck money in from existing investors, increasing competition and resulting in higher yields.
Moreover, many investors are not allowed to hold bonds that are not investment grade and would have to exit any fallen angel credits.
A raft of household names, such as carmaker Ford, airline British Airways and retailer Macy’s, had their ratings downgraded to junk as in March and April as about $193bn of debt fell to junk status amid the economic fallout from Covid-19.
“When bonds are downgraded from investment grade to high yield it can lead to forced selling and when sales volume is high it can limit absorption capacity in the market,” says Antoine Bouveret, senior economist at the European Securities and Markets Authority. “This can create a kind of amplification effect.”
It remains to be seen whether the market can continue to absorb the kind of high levels of credit downgrades seen in March and April, Mr Bouveret adds.
“[Since March and April] there have still been more downgrades than upgrades, but the numbers are slowing. The key question is whether those downgrades will arrive in clusters [causing market instability] or whether the process will smooth out over time.”
Between March and mid-August, there were 707 downgrades in North America, with the number of issuers downgraded coming in at 497, according to Debtwire. In Europe, the number of downgrades over this period was 380, with 248 issuers downgraded.
Of these downgrades, 26 qualified as fallen angels – downgraded to sub-investment grade – in the two regions.
Central bank support
While the downgrades have unsettled investors who had to sell down positions in newly sub-investment grade credits, the feared cliff edge that faced the market in March and April has been avoided, says James Greene, a corporate finance lawyer at White and Case.
“Support from central banks has helped to keep markets open for high yield issuance and avoid a fire sale of fallen angel credits,” Mr Greene says.
In the US, the Federal Reserve, which normally only purchases investment grade bonds, has put temporary measures in place to relax its requirements and continued investing in fallen angels and the European Central Bank has softened its position and is no longer insisting that collateral assets for a bond must be investment-grade quality.
Mr Greene adds that private and institutional investors have also adopted a pragmatic approach toward fallen angels coming to market or already in portfolios.
“Private investors have been sanguine about holding on to existing fallen angel credits. Although some institutions have firm red lines on non-investment grade bonds, many mutual and exchange traded funds can increase non-investment grade bond holdings within certain thresholds and have been able to digest higher numbers of fallen angel assets,” he says.
Fallen angel borrowers need to pay close attention to how any new borrowing is positioned to the market and their existing lender base, Mr Greene adds.
Low interest rates, coupled with their innate investment grade qualities, have kept an array of financing options open to fallen angels, but borrowers may still have to offer new debt on enhanced terms, he says. These terms could include better pricing, more collateral or additional covenants.
US cruise operator Carnival, for example, was downgraded to a non-investment grade rating in April and subsequently raised a $900m bond at a 10% coupon, using its fleet as security for the finance.
Debt issuance rising
Debt issuance has ballooned this year even as creditworthiness declined, as companies raced to increase their cash buffers, according to S&P Global Ratings.
Issuance of non-financial triple-B rated debt reached record high levels both in the US and Europe, the Middle East and Africa (EMEA) in the second quarter of 2020. At $246bn, the US total was up from $110bn in the first quarter, while EMEA issuance rose to $74bn from $30bn.
The increase in the amount of speculative grade debt issuance, however, has not been enough to reverse a decline in the yield of US high-yield corporate debt.
"So far the speculative-grade bond market appears to have comfortably absorbed debt that was recently downgraded from triple-B, though most bonds from recent fallen angels have been trading at relatively high levels compared with the speculative-grade composite," Nick Kraemer, head of S&P Global Ratings Performance Analytics, wrote in a recent report.
The ICE Bank of America US high-yield index option-adjusted spread rose from 357 basis points on February 19 to a peak of 1,087 basis points on March 23 as the pandemic took hold in the US, before falling back down to 502 basis points as of August 31.
