Opportunities with Fallen Angels in the Current Bond Market
Financial Markets
The awareness of the extent and characteristics of this crisis came late for many. The decline in sales of many companies was not 10% or 20% as in a normal recession, but collapsed to 30% or in extreme cases to 0% during the lockdown. The financial markets reacted violently.
The awareness of the extent and characteristics of this crisis came late for many. The decline in sales of many companies was not 10% or 20% as in a normal recession, but collapsed to 30% or in extreme cases to 0% during the lockdown. The financial markets reacted violently.
Stock markets experienced the lowest fall within a 10-day window, credit spreads rose sharply and liquidity in the bond markets dried up. Central banks and governments promised bailout packages that could be described as spectacular in size and form. This calmed the financial markets just in time and enabled companies and states to build up large liquidity cushions by raising debt on the capital markets in order to avoid imminent insolvency and to prepare for the long phase of reduced economic activity and the risk of rising infections again. Companies and sovereigns have raised more than 1500 billion in new euro-denominated debt to date - never before have so many bonds been issued in a single year. Even the major rating firms did not want to be accused of inactivity this time and quickly and widely downgraded ratings of companies. The result was a rapid increase in so-called Fallen Angels, i.e. companies that were downgraded from investment grade to high yield.
The summer brought recovery combined with a positive outlook. In the meantime, however, infections have risen sharply and the second wave is rolling over us. Despite record daily COVID-19 infections in much of the world, credit markets are reacting surprisingly unexcited. In contrast to March, credit spreads have barely risen. Possibly a consequence of more targeted measures by sovereigns and strengthened liquidity in firms.
The above-mentioned "Fallen Angels", namely the downgraded BB bonds, are currently valued at historically attractive levels compared with BBB bonds. This is illustrated in the following chart, which compares the credit risk premium ratio (i.e. additional yield) of BB vs. BBB bonds. A larger number indicates that BB bonds are cheap compared to BBB bonds. This ratio is unusually high at the moment, as it lies on the yellow dashed line, which indicates that the interest rate differential is 2 standard deviations above the average.
BB-Bonds vs BBB-Bonds
Source: Bloomberg
At the same time, it is interesting to note that subordinated bonds issued by investment grade companies (AAA-BBB rating range) have similar yields to BB bonds (highest credit rating category in the non-investment grade range):
Subordinated bonds
We draw the following conclusions from these observations
a) In an environment of uncertainty, we continue to expect increased volatility, reduced liquidity and an increasing rate of corporate bankruptcies with a focus on the non-investment grade sector (also known as "high yield")
b) calling the outlook for bonds heavenly would probably be overly optimistic; nevertheless, we see credit markets in a good position; credit spreads of corporate bonds vs. government bonds remain attractive in the current low interest rate environment
c) central bank support for bond markets remains unchanged and without alternatives
d) we prefer defensive companies and invest "best in class", i.e. in solid companies with strong market positions, sustainable cash flows & meaningful valuations
e) a broad diversification is mandatory for this higher yielding strategy, i.e. we hold at least 150 different borrowers in our bond portfolios
f) additional yield potential can be tapped via subordinated bonds of solid investment grade companies. Due to the lower default risk we currently prefer lower seniority compared to lower rated attractively rated Fallen Angels at comparable yields. Due to the increased default risk, we prefer BB bonds from companies with large capital structures, which have good access to the financial markets.
