Credit markets are bifurcated, and there’s a major yield difference between the perceived winners and losers. This trend is creating a lot of questions—and potential value—for credit investors. Here’s my take on the current environment and why I’m excited about the opportunity it’s creating.
Can the high yield market absorb a flood of fallen angels?
Many aspects of this COVID-19 environment feel unprecedented. But so far, the fallen-angel downgrades we have seen are pretty typical of an economic downturn. During February and March, about $130 billion of debt was downgraded to high yield. The 2009 and 2002 downturns saw about $141 billion and $125 billion, respectively, of fallen angels.
What’s different this time? The velocity, for one. This cycle, it only took two months to notch $130 billion of fallen angels. In 2009 and 2002, it took about six months to reach roughly that level. Another is the scale of looming potential downgrades. The BBB universe hit an all-time high of $2.6 trillion in December 2019.1 Loomis Sayles’ credit research analysts have identified roughly $678 billion of BBB bonds (or 21.1% of the BBB market) as having medium or high risk of downgrade.2 To put that figure in context, the entire BB market is $666 billion.3
The amount of BBBs at risk of downgrade and speed at which companies have deteriorated have raised concerns that fallen angels could overwhelm the high yield market. I think the downgrade trend will continue. It certainly won’t be painless, but downgrades on that scale could potentially create a lot of interesting opportunities for investors. Forced selling should prompt bonds to change hands in already illiquid markets, which can lead to mispricings.
What industries are most vulnerable to additional downgrades?
At an industry level, the initial $130 billion wave of downgrades was made up mostly of autos and energy issuers. Some of these were companies we believed were vulnerable to downgrade when economic conditions turned because of leverage levels, operational shortcomings, or industry challenges. The other major source of downgrades was company-specific strategic decisions; for example, maintaining dividend payments.
Looking ahead, the most at-risk industries include airlines, retailers, consumer product companies, energy, and cyclicals like autos. The severity hinges on questions that are difficult to answer. When do widespread quarantines end? When will people start going out to eat, traveling, returning to school and work? Will the crisis change consumer behavior long term? Will the virus have a second surge? When will widespread testing and vaccinations become available? All of these factors will play out eventually, but some companies can’t wait long. The rating agencies have moved quickly so far, and that could continue. The agencies’ actions will be a big determinant of future downgrades. Will rating agencies see COVID-19 as temporary and look through the near-term effects? Or could they move the goal post and change the definition of what qualifies as investment grade credit? Uncertainty and default concerns are likely to cause swings in spreads throughout the recovery.