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 

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