Debt, Downgrades and Fallen Angels: Keeping Risks in Perspective

The market has grown less anxious about an imminent wave of bond downgrades. That’s good, because overestimating the risk can lead to missed opportunities. But the risk hasn’t disappeared, making research as important as ever.

At the end of 2018, nearly $140 billion worth of BBB-rated bonds were trading as if they were already below investment grade, reflecting widespread concern about unsustainable corporate leverage. That’s the kind of thing bond investors find hard to ignore—with good reason. A wave of downgrades could lock in big losses for investment-grade strategies and spark a disruptive repricing in the high-yield market, a risk for high-income-oriented portfolios.

At the time, we said that a group of US investment-grade bonds worth a much smaller amount were at risk of becoming fallen angels, as formerly high-grade bonds are known. Our research suggests about $80 billion worth could tumble to high yield (Display 1), and we think the process could take years to play out.

The market has recently edged a bit closer to our point of view. Demand for BBB-rated bonds surged in the first quarter, with the sector delivering returns of nearly 6%. Why the change of heart? Probably because conditions have changed. Six months ago, the Federal Reserve expected to raise rates three times in 2019. Now, it says it won’t raise them this year at all. This may sustain US growth and ease pressure on corporate borrowers.

Don’t get us wrong: some of the companies still clinging to the bottom rung of the investment-grade ladder will become fallen angels this year. That’s not so unusual, though. A certain number of investment-grade bonds are downgraded to high yield every year—about $72 billion worth on average each year between 2009 and 2018 (Display 2).