Just before the global pandemic, we published Don’t be Afraid of BBB Credit. What follows is an updated perspective on BBBs and fallen angels in light of the Great Lockdown.
Fallen Angels: Theory To Reality
As a direct result of COVID-19, the threat of an increase in fallen angels has materialized, with large capital structures like Ford (~$40bn) among the first to be impacted.
Approximately $150bn of BBBs have been downgraded year-to-date, and we would not be surprised if the year-end total is double this as another $300bn is already on negative outlook (Source: JP Morgan, May 2020).
So Now What? Separate The Fallen Angels From The Falling Knives
After a downgrade, some fallen angels may offer potential opportunities amid forced selling from passive funds, as long as the company will still be able to repay at par. Others though may be on the way to distress or default—and so would just be falling knives—and best avoided.
The potential opportunity typically occurs just after fallen angels’ transition from investment grade to high-yield indices (usually the end of the month of the downgrade). Unsurprisingly, they tend to underperform (i.e. widen relative to) their investment grade peers just before the transition, but they tend to outperform (i.e. tighten relative to) their new high-yield peers just after the transition (Figure 1).
Figure 1: Fallen Angels Tend To Outperform Just After An Index Transition
(Source: Credit Suisse, April 2020)
We believe an investment grade strategy could potentially benefit from investing in the right fallen angels just after a downgrade—if investors can properly identify companies with the liquidity, balance sheet strength and ultimately, staying power to avoid a default. Investors need to be in a position to take advantage quickly, such as already being invested in a vehicle that can seek such opportunities.
By the same token, Figure 1 demonstrates that BBBs facing imminent downgrade may often be ideally avoided.