For investors, the strategy is to avoid those companies that exhibit traits of becoming fallen angels and own those which have all the qualities of the phoenix.
FALLEN ANGELS
(source: Bloomberg)
In the Divine Comedy (1308–1320) by Dante, Fallen Angels guard the City of Dis surrounding the lower circles of hell. Dante’s Fallen Angels mark a transition point; in previous circles, the sinners are condemned for sins they just could not resist, later on, the circles of hell are filled with sinners, who have deliberately rebelled……
If we consider Dantes “circles of hell as rings of credit ratings, those corporates that deliberately embraced the lure of “efficient” and leveraged balance sheets, clearly, are now being relegated to spend time in the City of Dis, the land of sub-investment grade bonds.
Financial Market’s fallen angels…
The term, “Fallen Angel”, is used to describe bond issuers who have previously enjoyed a solid credit rating above the BBB line which is used to delineate Investment Grade from High Yield. In particular, the phrase relates to bond issues that have been downgraded by rating agencies from the coveted BBB and above credit arena to the lower rated universe of high yield, or to use American parlance, “Junk”.
It has been seen that, absenting those companies associated with fraud, many companies who enter the world of sub-investment credit ratings, having previously held an investment grade rating, generally recover the BBB and above status after a period of time that entails many acts of self-repair. This would involve retrenchment from marginal business lines and geographic locations coupled with dedicated efforts to reduce debt and leverage. Frequently this also entails sweeping changes of management; the replacement of the failed team with specialists in corporate recovery, followed by another new team that can grow the business once more within the confines of the new structure.
If this repair and recovery process is completed and provided the focus of the business is still viable in this fast changing world, then gradually profitability is restored and balance sheet leverage is visibly reduced allowing the Company to rise, Phoenix like, out of the junk bond market fire.
For investors, the strategy is to avoid those companies that exhibit traits of becoming fallen angels and own those which have all the qualities of the phoenix.
At this stage of the market cycle, we expect to see many companies fall into the fallen angel category. The number of BBB, highly leveraged corporates as a percentage of the overall market is high. Many of them are simply ordinary companies whose business entails relatively high leverage because of low margins, providing products or services that are essential. A good example of this would be National Grid, whose total debt to EBITDA stands at 5.6x (this is high) and meaningless zero / slightly negative free cashflow means it operates on the cusp of investment grade status at A- from S&P and BBB. The company however, owns and operates a national utility of utmost importance, the electricity grid, whose value is uplifted on an inflation adjusted basis. There is a perceived link with it’s credit rating and that of the United Kingdom. If there were to be, say a several notch downgrade to the country rating, it would probably push down the rating of National Grid as well. Should the credit downgrade mean it reaches BB status, then National Grid will be classified as a Fallen Angel. There is no suggestion that this will happen by the way and Nat Grid is only being used to outline how a credit downgrade on any type of company would work out. So, the question is what happens to the bonds of National Grid if this credit downgrade were to happen?
Tesco: a classic case study
To look at the future, sometimes, it is right to look at the past. Tesco, in the period around 2011/2016 went through a period of corporate turmoil. It’s mantle as the premier in UK food retail was under assault from discounters, Aldi and Lidl. Their stores were seen as being tired and it’s like for like sales were slipping, along with market share. Right on cue a scandal regarding financial reporting surfaced and management had to go. The continuous bad news on the Company left investors feeling uncertain as to it’s long term profitability and at worst, it’s viability.
Tesco shares sank, of course and it comes as no surprise to see that its bonds also sank. Bond investors were concerned that the boring return metrics of coupon flows and nominal return on maturity were at risk.
Yield expansion (price decay; yield up, price down) really started in 2014 in anticipation of not only the potential for worse news to come, but also the potential for more credit rating downgrades as S&P reinforced the diminishing outlook, putting Tesco on credit watch negative, whilst the rating was at BBB. In the first quarter of 2013, Tesco Yields were at their tightest levels against benchmarks.
Despite the fact that there were still some credit “notches” between BBB and BB+, the price of Tesco Bonds fell dramatically. The yield “spread” rose by 120 basis points, immediately anticipating a move to Junk, BB rated credit status. Of course, over time the story grew and the company was put into BB / Junk status. The bonds continued to suffer, with yield spreads hitting a peak of 540 basis points in Feb 2016 (aided by a credit sell-off at that time). Junk bond status occurred in Jan 2015, several months after the violent lurch upwards in Tesco’s yields and the fact of the matter was that, on achieving Junk status, the credit spread tightened.
The mechanics of the move wider in bonds are therefore that investors will anticipate rating actions, by quite some time as dedicated, investment grade bond investors seek to protect themselves from having to sell bonds once they are moved into sub-investment grade status.
However, once an issue becomes Junk, it is, generally seen as being a good credit by dedicated junk, or high yield bond investors. With Tesco, the story gradually grew over the course of 2015, causing bonds to widen even further to the +540 basis point peak. However, from there, the rehabilitation began, not only in the stores and business, but also in the credit profile, such that by November 2019, Tesco achieved investment grade status once again, causing the bonds to rally strongly as the credit spread contracted and investment grade investors, belatedly bought back the bonds they had sold at a loss a few years previously.
Tesco is a classic Fallen Angel story. For bond investors it highlights, Fallen Angel Index rules that bonds are bought when they fall from investment grade credit and are sold when they return back to investment grade, which more often than not means these bonds are bought at a low price and sold at a high price, which is of course the right way to do it…
The only problem occurs when companies keep falling through credit rating bands in a downward spiral. This implies that a company will eventually default and here the rules are the same as for when an issuer falls out of investment grade to Junk. The company is ejected from the index, no questions asked, which may mean an even greater loss than the initial fall from BBB to BB. However, a drop from a C rating to D “default” really implies complete loss or at best a recovery of around 30% of face value. In the context of Fallen Angels this is usually seen in the case of fraud. Generally, highly leveraged companies which are the main segment of issuers that fall into default, start their bond issuance programmes at BB and below, which means they are not defined as fallen angels.
In this market environment, it is highly likely that the Fallen Angel segment of the bond market will expand at a rate never seen before. Given the rules of Fallen Angel investing – buying once the credit rating damage has been done, the very point when investment grade investors have to sell – it may be the case that this segment is overwhelmed and credit spreads widen to much greater levels that history has previously shown.
Buying 50p Pounds
A phrase purloined in 2008/09 to describe taking positions in deeply under-water subordinated bank debt, may be one way to approach this market turmoil. It should also be pointed out that during the time a bond issuer is “Junk”, it still pays interest. It’s equity relation will probably have stopped paying dividends.
Over the course of the last 10 years, Fallen Angels have, up to the end of 2019, unsurprisingly, outperformed investment grade by 50% points; US Investment Grade Corporates have returned a healthy 78% (annualised 6.23%) vs Fallen Angels 127.91% (8.99% annualised). What is perhaps surprising is that Fallen Angels have also outperformed High Yield Corporate Bonds, by some 27%. Bear in mind that the High Yield index is broadly based and includes Fallen Angels. What this tells us is that the recovery potential and therefore positive performance potential of a Fallen Angel, returning back to Investment Grade is comparatively much better than owning pure high yield, pure investment grade, or even a classic Core-Plus 60/40 combination of both.
Of course, in the current market, all corporate debt has lost ground and investment grade bonds are “only” down 10% since the start of March. Fallen Angels are down 13.9%, in line with High Yield at 14.13% (to 27th March). Maybe this period of inline and underperformance against investment grade will represent an opportunity to take a long-term view on the asset class.
Whilst the Corona Virus continues to affect society and economies in unexpected ways and it is still difficult to really understand how markets will react, we will retain an underweight investment stance. However, once we can quantify the extent of all the damage, a closer look at Fallen Angels will be in order.
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About the Author
Peter Smart, Head of Investments
01534 488778
Peter has been involved in investment markets since 1985, working within the private client areas of two global banks and for 22 years as the fixed income specialist for the UK Wealth manager, Brewin Dolphin. More recently Peter formed part of the investment team at bridport in Jersey specialising in the provision of specialist, income focussed portfolio’s.