April 16, 2020

Fallen Angels & the Fed

Profile picture for user Peter Duffy
Peter Duffy, CFA
CIO - Credit, Sr. Portfolio Manager

April 30th will see record fallen angel bonds move out of investment grade indices, more than the entirety of 2009. In response, the Fed has expanded its credit facilities to purchase fallen angels and HY ETFs. We believe this has significant implications for bond investors, especially as crisis period trends tend to repeat themselves.

$150bn of YTD Fallen angel volume already surpasses 2009. In response, the Fed recently expanded its Secondary Market Corporate Credit Facility (“SMCCF”) to purchase fallen angels, as well as high yield bond ETFs. This backstop provides liquidity and price stabilization, helping to keep credit flowing amid the pandemic. But it does little to help cash-strapped companies from declaring bankruptcy. High yield bonds offer attractive rebound potential, but investors will need to select quality issuances to help avoid defaults.


Forced selling will likely see fallen angels enter the high yield space at deeper than average discounts, further intensified by record volume and postponed rebalancing. ICE BofA postponed its 3/31 index rebalance, which would have seen $116bn of fallen angel outflows from investment grade indices. The upcoming 4/30 rebalance will include April and March, seeing more fallen angel flows in one month than the entirety of 2009.


Fallen Angels Volume and % of High Yield Market (Exhibit 1)
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As of 4/15/2020. Source: JP Morgan.


Extreme fallen angel volume periods have historically favored high yield bonds, as the bonds trade down prior to being downgraded. Post downgrade, the discounted issues often exhibit relatively strong balance sheets, with roughly two-thirds remaining BB-rated over the following 3 years. Excluding 2020, the top 5 periods of fallen angel volume from exhibit 1 are 2016 (Energy), 2009 (Financial), 2005 (Auto), 2002 (Accounting scandals), and 2001 (Dotcom & 9/11). High yield bonds delivered outsized returns in each period, surpassing the aggregate bond market and even equities, as shown in exhibit 2.


Top 5 Fallen Angel Volume Years and Asset Class Returns % (Exhibit 2)
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As of 4/15/2020. Source: Bloomberg. Indices: ICE BofA High Yield, ICE BofA Fallen Angels, S&P 500, BbgBarc Agg Bond.


The Fed has taken extraordinary measures to ensure liquidity flows throughout financial markets, launching three credit facilities to purchase and stabilize corporate credit: (1) primary market “PMCCF” for IG and fallen angel new issues, (2) secondary market “SMCCF” for IG bonds, fallen angel bonds, IG ETFs, and HY ETFs, and (3) commercial (“CPFF”) for commercial paper issuers. A more detailed breakdown can be found in exhibit 2, as well as a comparison of the Fed to other central bank activities.


Fed Credit Facilities Details as of 4/9/2020 (Exhibit 3)
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As of 4/9/2020. Source: Board of Governors of the Federal Reserve.


In conclusion, high yield bonds have historically offered excellent performance to long-term investors, with a higher return than the S&P 500 and agg bond market in the 20-year period ended 3/30/2020*. High yield managers and more tactical investors should consider the implications of fallen angel volume, Fed activity, credit conditions, historically similar events, and post-crisis rebound potential. The pandemic will eventually subside, and high yield companies with strong balance sheets will likely rebound significantly, as they have after in every major crisis over the last 25 years.


Historical Credit Spreads and Crisis Periods (Exhibit 4)
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As of 4/15/2020. Source: ICE BofA. Index: ICE BofA High Yield Option Adjusted Spread Index.

 

A PDF Version can be found here.

 


 

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The S&P 500 index is comprised of the 500 largest US publicly traded companies. The ICE BofA US High Yield Index tracks the performance of US dollar denominated below investment grade rated corporate debt publicly issued in the US domestic market. The ICE BofA US Fallen Angel High Yield Index tracks the performance of US dollar denominated below investment grade rated corporate debt, that had previously been rated investment grade prior to being downgraded, publicly issued in the US domestic market. The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed rate taxable bond market. The ICE BofA High Yield OAS (Option-Adjusted Spreads) Index is the calculated spread between a computed OAS index of all bonds in a given rating category and a spot Treasury curve. An OAS index is constructed using each constituent bond weighted by market capitalization. The ICE BofA US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market. A copy of Penn Capital’s current written disclosure statement discussing our advisory services and fees is available upon request. Investors cannot invest directly in an index.