Multi-sector corporate credit: flexibility matters in the search for yield

Taking advantage of the potential mispricing of fallen angels

About $150 billion worth of U.S. investment grade rated bonds have been downgraded to high yield this year. This makes up about 2.1% of the $6.8 trillion U.S. investment grade corporate bond market, 4.5% of the $3.3 trillion BBB market, and 10.3% of the $1.5 trillion U.S. high yield market. The sectors that have been most impacted by the pandemic – energy, auto and retail – have suffered the greatest “fallen angel” risk. Many BBB bonds have traded at levels in-line with BB names, implying an impending downgrade from investment grade to high yield. In some cases, at-risk BBB bonds are priced even below comparable BB bonds in their sector.

The forced selling of fallen angel bonds by investment grade indices, ETFs and fund managers, which must maintain investment grade guidelines, has contributed to this phenomenon. Furthermore, downgrades to below investment grade can have meaningful implications for institutional investors such as pension plans and insurance companies with respect to managing their asset-liability and risk-based capital needs. As such, we often see prices of fallen angels being pushed below their intrinsic value. We believe this potential mispricing creates attractive opportunities for managers that have the flexibility to invest across the credit ratings spectrum, particularly in the BBB and BB “crossover” space.



One recent study in the Journal of Financial Economics found that the forced selling of fallen angel bonds led to an average price decline of nearly 9.0% in the five weeks following the downgrade from investment grade to high yield. It also found that the prices of these issues recovered their fundamental value by the end of 30 weeks. Intuitively, this does not come as a much of a surprise, as the credit profile of fallen angels tend to be higher quality than traditional high yield issuers. Many fallen angels tend to be large, established businesses that despite near-term business pressure, still possess numerous tools to preserve balance sheet flexibility. For these fallen angels, an upgrade back to investment grade can lead to attractive risk-adjusted returns.

This example by Morningstar during the Q1 selloff illustrates the pricing phenomenon we often see in the BBB – BB market. Upon Ford’s rating downgrade from BBB to BB, the price of its 2026 issue experienced a severe decline, falling below the price of the BB rated Fiat bond, which retained its credit rating during the period. At the end of April, while the price of the Ford bond was still trading significantly below par, its appreciation off the lows was greater than the similarly rated Fiat bond.

The Ford example is one of many that we see in the credit market today. In our view, the coronavirus crisis has led to more dislocations in the market, particularly in recently downgraded or at risk BBB bonds. Comparing BBB to BB spreads, we see that BBs offer attractive spread pickup over BBBs not seen in the previous five years, while being much higher than the long term average. We believe that flexible investors that can invest across the ratings spectrum in multiple sectors may be able to take advantage of these pricing inefficiencies and find attractive risk-adjusted return opportunities.

Identifying winners and avoiding losers in the corporate bond market

Within the corporate bond market, a record number of issuer defaults is projected in 2020. At the end of June, the U.S. high yield default rate reached a 10-year high of 6.6% according to J.P. Morgan research, as compared to the long-term average rate of 3.4%. Through the first half of the year, there has been a total of $106.1 billion of defaults in bonds and loans including distressed exchanges, which ranks as the second highest default total on record, trailing $205 billion in 2009.

It’s noteworthy that not all sectors have been equally impacted, but rather certain sectors such as energy have faced the greatest concentration of defaults, which has accounted for 27% of defaults this year through the end of June. With oil prices at unsustainable levels, many issuers are currently trading at distressed levels, and we expect this trend to continue through the year. Given risks of corporate defaults and additional spread widening due to uncertainties around economic growth, we expect there to be heightened bifurcation within the corporate bond market, separating winners and losers. Furthermore, we believe that fundamental, bottom-up security selection will be instrumental towards generating attractive risk-adjusted returns.

The energy sector, which comprises the largest weighting in the high yield index and the second largest weighting in the investment grade corporate bond index, is suffering from a depression in demand due to the shutdowns and increased supply stemming from pricing disagreements among OPEC+. We are defensive on the sector as the damage to energy prices and unsustainability of companies to operate at below break-even prices should lead to continued bleeding of cash flow and elevated default levels. We anticipate that the energy sector will be the main driver of default rates in 2020.

On the other hand, we believe that health care and technology, two of the better performing sectors year-to-date, should continue to benefit. Default rates in both sectors are expected to remain low and we feel implied option-adjusted spreads (OAS) are currently compensating us for the credit risk. Within health care, we believe the sector provides innovation-fueled growth, strong underlying cash flows, and minimal fundamental impact from the coronavirus relative to other industries. While political and regulatory concerns are warranted, broader health care adoption opens avenues to capture additional wallet-share and the industry has and will likely continue to generate excess for returns for innovation. Within technology, the sector has outperformed the broader market YTD and following the Q1 selloff. We believe various sub-sectors within Technology stand to benefit from “work-from-home” safe-haven trades, with software, internet, and video games benefiting most.

Adding credit exposure to your fixed income allocation to achieve your income goals

In light of low interest rates and slower economic growth, we believe that thoughtful construction of an investor’s fixed income allocation is paramount to achieving his or her income goals. In our view, traditional or “core” sources of income alone are no longer sufficient in producing the yield many investors are looking for. We believe that adding credit exposure in the form of investment grade and high yield corporates, preferred securities, and convertible bonds can provide enhanced yield and attractive risk-adjusted returns to an investor’s fixed income allocation. For institutional investors, we view the increased income potential as particularly compelling. In the asset-liability space, generating enough current income to meet near-term liabilities can help immunize the front-end of a plan’s liabilities. Also, the risk of greater mark-to-market volatility that comes with investing in higher yielding credit can be effectively reduced by laddering these bonds to match up with liabilities.

That being said, we acknowledge that investing in the higher yielding areas of credit comes with certain risks to be mindful of, and we caution investors to avoid overreaching for yield. For instance, the combination of low borrowing rates, relaxed issuance standards, and starved demand for income has led to significant growth in the leveraged loan universe following the 2008 financial crisis. The pandemic brought these concerns to a head as many companies that had taken substantial leverage previously now have limited balance sheet flexibility and fewer tools to maneuver through the current environment. Looking across the world, we see growing differentiation within emerging market economies with some being more reliant on commodity prices than others. We believe this will likely increase the variance between the return outcomes within EM debt. In contrast, we are constructive on the U.S. as we think economic fundamentals domestically look more solid relative to other markets in general.



 

Within U.S. credit, we are finding opportunities in the IG and HY corporate bond market, as well as in preferred securities and convertible bonds. Historically, these areas have been a reliable source of attractive risk-adjusted returns, and we believe that taking an active approach towards investing in these areas can lead to compelling risk/reward going forward. We think preferreds and convertibles are often overlooked by institutional investors, which can create opportunities for skilled managers to capitalize on market inefficiencies. These assets can serve a nice role in a portfolio, not only generating attractive yields, but also enhancing a portfolio’s return profile by combining equity-like upside potential with bond-like downside protection.

With respect to corporate bonds, we view the massive pledge by the Federal Reserve to support the corporate bond market as a tailwind for the asset class. Since the Fed’s announcement on March 23, we’ve seen spreads tighten dramatically, and through the end of June, approximately $10.1 billion of corporate bond ETFs and individual bonds have been purchased. With hundreds of billions available to provide technical support to the corporate bond markets, we are optimistic that spreads have a lower likelihood of retesting the wides seen in March. We remain constructive on BBB risk as they have the strongest incentive to de-lever, and are attractively valued given the wide BBB-A spread differential. As corporate spreads still remain off the tights seen during the beginning of the year, we maintain a positive view on corporate credit for the near future, and focus on individual credit selection as a key driver of generating excess returns.