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BBB bonds face their moment of truth
David Bradin
Fixed Income Investment Director
Hillary Cookler
Senior Investment Product Manager
KEY TAKEAWAYS
  • Downgrades of BBB-rated bonds to high yield are on track to top their prior peak.
  • Fallen angel and BBB bond price declines can provide investment opportunities.
  • More downgrades are likely as the weak economy is hurting revenue and cash flow.

 


Bonds rated BBB or Baa — the lowest rung of the investment-grade market — have ballooned to US$2.3 trillion in recent years. Now, amid the economic crisis triggered by the coronavirus outbreak, a wave of downgrades appears to be underway, which could cause sharp declines in bond prices. In this Q&A, fixed income investment director David Bradin and senior investment product manager Hillary Cookler discuss the potential for further downgrades and the broader impact on this segment of the bond market. 


 


What have we seen in the bond market as the crisis has unfolded?


The sharp economic downturn arising from the coronavirus pandemic has already taken a toll. More than 20 US companies were downgraded to high yield (BB/Ba and below) during the first quarter, compared with 12 in all of 2019. These downgrades represented US$143 billion of investment-grade (BBB/Baa and above) debt1, close to the peak reached during the global financial crisis in 20092. Three “fallen angel” downgrades from BBB — Ford, Kraft Heinz and Occidental Petroleum — accounted for a large percentage of the downgraded debt.


At the same time, market volatility spiked. In March, corporate credit spreads hit their highest levels since 20093, and Treasury market liquidity tightened considerably. Unprecedented intervention by the Federal Reserve — including a pledge to buy the bonds of investment-grade companies and recent fallen angels — helped to reduce volatility and narrow spreads. It also spurred record-breaking bond issuance as companies took advantage of historically low interest rates to build cash on their balance sheets in anticipation of a deep recession.


 


Given the economic environment we are in today, do you expect further migration of companies from the BBB segment of investment grade to high yield?


For much of the BBB segment, there is little immediate risk of downgrades to high yield. Many BBB-rated companies are large, with meaningful free cash flow generation, multiple ways to reduce leverage and a sizeable equity cushion below their debt. Such issuers can reduce or halt dividends, sell non-core assets to raise cash or prioritise the use of cash flows for net debt management in order to avoid a downgrade. 


Nevertheless, there are many BBB companies that entered the crisis in a weaker position and will likely be unable to avoid a downgrade. These companies are burdened by high net leverage, constrained liquidity, upcoming debt maturities or business models that are highly exposed to the economic dislocations caused by the pandemic.


 


Does that mean more fallen angels?


Yes, we think more downgrades and debt defaults are likely. Corporate leverage remains high and companies in many sectors are experiencing sharp declines in revenue and cash flow. After the criticism they faced in 2008–09 for being slow, credit rating agencies are moving aggressively to revise their outlooks and ratings as the economic fallout of the coronavirus pandemic comes into focus. Ultimately, it will depend on the depth and duration of the downturn and what actions BBB companies can take to avoid a downgrade. 


Sell-side analysts estimate that US fallen angel downgrades could reach US$350 billion for all of 20204. That estimate is consistent with prior downturns, when such downgrades hit roughly 15% of the total market value of BBB companies, excluding financials. If fallen angels reach that level, it would double the size of the US BB bond market, which was valued at US$349 billion at the end of the first quarter5. While details about the Fed’s pledge to buy fallen angel debt are still emerging, its presence would help the market absorb these new entrants into the high-yield bond market and has already supported prices there.


 


What do these downgrades mean for bond investors?


Once a company’s debt reaches high-yield status, its bonds can come under forced selling by fund managers whose guidelines prevent or limit positions in securities rated below investment grade. The negative technical pressure of forced selling can result in price dislocation and volatility. An exaggerated downward price move triggered by a fallen angel downgrade can present an attractive buying opportunity for high-yield investors.


1. Source: JPMorgan. Using Moody’s, S&P rating agencies. As at 31 March 2020. 


2. Source: JPMorgan. Using Moody’s, S&P rating agencies. As at 31 March 2020. 


3. Source: Bloomberg Barclays US Corporate Bond Index. Spreads hit their highest levels on 23 March 2020


4. As at 1 April 2020. Source: Bloomberg news article


5. As at 1 April 2020. Source: JPMorgan 

 

Risk factors you should consider before investing:

  • This material is not intended to provide investment advice or be considered a personal recommendation.
  • The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
  • Past results are not a guide to future results.
  • If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease.
  • Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.


David Bradin is Fixed Income Investment Director for credit strategies. He has 14 years of industry experience. He holds an MBA from Wake Forest University and a bachelor's from North Carolina State University.

Hillary Cookler is a senior investment product manager at Capital Group, home of American Funds. She has 14 years of industry experience and has been with Capital Group for one year. She holds an MBA from Yale School of Management and a bachelor's degree in history and economics, graduating magna cum laude, from New York University. Hillary is based in Los Angeles.


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Past results are not a guarantee of future results. The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment. This information is not intended to provide investment, tax or other advice, or to be a solicitation to buy or sell any securities.

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