High-yield investors in search of bargains and liquidity have so far embraced a US$130bn wave of fallen angels, but analysts are warning against complacency as the potential list of casualties grows.
A big fear in corporate credit in recent years has been that a flood of fallen angels - companies downgraded from investment grade to junk ratings - would swamp the high-yield index and lead to forced selling and a meltdown in the bond market.
But so far, demand for fallen angels such as Ford, Occidental, and Kraft-Heinz, has meant there has been little disruption, helped by the Federal Reserve's backstop measures.
High-yield investors are being drawn to these names by the discounts on offer but also the higher perceived quality.
"The Triple-B companies that are falling are the worst of Triple-B, but they quickly become some of the bigger and better names in high-yield," said Adam Spielman, head of leveraged credit at PPM America.
Indeed some high-yield investors have developed specific strategies to focus on fallen angel bonds - which tend to trade at a discount with the potential to outperform as investment-grade accounts offload the bonds cheaply.
"It does take somewhat of a contrarian mindset," said Manuel Hayes, senior portfolio manager for high-yield and fallen angel strategies at Mellon. "When we see lots of downgrades we see opportunity."
Ford Motor Credit, for instance, is rated Ba2/BB+/BB+, but trades more like a Single B credit.
Ford's 3.65% notes due 2024 were trading at a cash price of 85 to yield 8.01% on Wednesday, according to MarketAxess - close to the 7.99% average yield on Single B names in the ICE BofA index.
RISKS AHEAD
Still, it is early days in what could be a long cycle of downgrades and the reception of the first wave of fallen angels in March and April may underestimate the risks ahead.
Analysts at CreditSights expect a further US$300bn-US$400bn of fallen angels over the next 12-24 months, in addition to the US$200bn the firm estimates has already dropped from IG to high-yield.
Banks such as Deutsche Bank and Bank of America have lower estimates of around US$190bn-US$280bn in potential fallen angels over the next 12 months.
There are currently around US$1.3trn outstanding bonds in the high-yield market.
And the optimism in credit markets that met fallen angels like Ford and Occidental in March and April may already be starting to fade.
Growing doubts about the trajectory of corporate credit quality already seem to be showing up in average high-yield spreads, which have plateaued in the mid-700bp area over Treasuries after rallying sharply from over 1000bp in late March through April.
The impact of the coronavirus on the economy will leave lasting damaging on company balance sheets even as central bank and government measures help access funding, CreditSights analysts wrote.
"The increasing expectation that the longer term damage will be greater than originally expected is probably at least one reason for spreads flat-lining," they said.
LONGER TERM DOUBTS
The longer term case for holding fallen angel debt is that they tend to be higher quality names than the broader high-yield index, have more liquid capital structures, and more levers to pull to return to investment-grade status.
But these assumptions are being called into question by analysts.
A report from Deutsche Bank said on Wednesday that the idea that the majority of fallen angels become rising stars was a misconception.
Only 19% of fallen angel debt ends up a rising star, they said, and a not too dissimilar amount (12%) actually defaults, they said.
And the idea that fallen angels also improve the overall credit quality of the high-yield index by adding more Double B is also questionable, according to a Bank of America report on May 8.
"Experience from previous credit cycles shows that internal HY downgrades fully offset any growth in BBs from IG entrants," wrote BofA analysts.
FLEXIBLE MANDATES
Even so, fixed-income investors have proven more flexible than expected in dealing with fallen angels, which has helped mitigate the disruption.
"The perception of forced selling is outdated, there has been more flexibility on the IG side," said one fund manager.
"It's not like back in the day when you saw auto companies downgraded and there was a massive avalanche of selling. Now it is much more managed."
This could help blur the traditional lines between investment-grade and high-yield mandates as the fallen angel component becomes a bigger part of fixed income.
But it will take time for greater numbers of investors to adapt.
"The market is going to have to quickly adapt to this larger inflow of supply and there will certainly be some technical indigestion," said Paul Benson, head of fixed income efficient beta at Mellon.
"On the margin there are certainly investors that are looking to redesign their investment strategy but this is going to be on the margin, and I think it will take time to have a structure that reaches deeper (into lower rated bonds)."