Fallen Angels Provide Reward, and Risk
October 8, 2009
While credit quality is improving, as evidenced by the slowing pace of downgrades and defaults, there are still many more investment-grade companies likely to join the junk pile than companies poised to jump up the credit spectrum. The increased supply of high yield issuers is good news for investors looking for higher quality credits, but it could result in the dumping of their lower-rated counterparts, as portfolio managers move to take part in deals from companies new to the junk market, sources said.
Fitch Ratings found that there are three time as many companies likely to be downgraded to speculative grade from investment grade over the next year or two than there are junk companies set to move up to i-grade, according to a recent report. The 66 fallen angels recorded by Standard & Poor’s so far this year accounted for $223 billion in debt, which nearly matches the 2008 fallen angel debt total of $226 billion. However, S&P’s downgrade-to-upgrade ratio was three-to-one for the third quarter 2009, which is a decline from past quarters.
Of S&P’s rating universe, 34% of companies either had a negative outlook or ratings on CreditWatch with negative implications as of Sept. 22. This is up from 26% at the end of 2008 and 14% at the end of 2007. The U.S. leads the world in bonds with downgrade risk, with approximately 53% of its rated companies showing downside risk. Europe is a distant second place with 22%. Finance companies were the most likely be to be cut down to junk, according to S&P, with 12 issuers listed as potential fallen angels. Banks were in second place with nine entities, and utility companies were a close third with eight. The biggest fallen angel so far this year has been CIT Group, which has more than $38 billion in rated debt.
“Some might be concerned about the new supply created by the downgrades. I’m not,” said Matt Eagan, a portfolio manager with Loomis Sayles. “These at-risk credits already trade as if they were rated high yield. In most cases, the bonds have changed hands from investors that had to sell for fear of downgrade (or worse) to investors willing to take on the elevated credit risk for high yield return potential. So, the effect on the market is often negligible when the downgrade actually occurs. … Also, I think the high yield market could use more supply based on the level of cash flowing into the sector.”
And as Eagan points out, there are more then enough willing buyers for the newcomers to the junk market. High yield bond issuance picked up the pace towards the end of the third quarter, with a record September of $26 billion in deal volume. That makes September 2008 the second most active month of the year for junk bond issuance and the third most active month on record, according to JPMorgan. So far this year, high yield companies have priced more than $120 billion in new high yield bonds, but they’ve syndicated only $19.1 billion in leveraged loans to institutional investors, according to JPMorgan.
And while issuance in September increased after two months of slowing down, the credit quality of the companies coming to the high yield bond market decreased. Until May, no company rated CCC or lower managed to price anything. And only three issues rated CCC or below priced bonds before September. But September saw a total of five companies issue bonds rated in the CCC range, and two CCC-rated bond offerings came in the first week of October. On the flipside, fallen angels can provide investors looking for credits in the BB range with the supply they need.
“From an investment perspective, fallen angels, though more erratic in returns, have much higher returns than companies that were born high yield,” said Diane Vazza, a managing director with S&P.
However, the danger in the new supply of high yield companies could come in the form of high yield investors dumping lower-rated bonds in order to take part in deals from companies new to the junk market, said Kingman Penniman, CEO of KDP Investment Advisors. “Investors who are index oriented will start to buy some of the fallen angels and, in order to do so, will sell some of their other bonds. … As people switch over to buy them, what does that do to prices?” Penniman notes this could have a wide impact on secondary prices in the high yield market, as fallen angel companies are larger than average high yield companies and would be pricing large issues. This could mean a glut of bonds would enter the secondary market, driving prices down.
And if new issuance continues at or near its current pace, pricing pressures could affect both the primary and secondary markets if demand cannot keep up with supply. “There will be a significant amount of demand in 2012 and 2013 in the high yield market,” said Nick Nilarp, an analyst with Fitch. “That could put pressure on lower-rated names from a capital infusion standpoint over next couple of years.”
And things are changing, although slowly, in the ratings universe. Despite the still lopsided ratio of potential fallen angels to potential rising stars, the pace of downgrades is slowing, according to a recent Fitch report on corporate downgrades. Downgrades have shrunk by 52% quarter-over-quarter this year, with the ratio of downgrades to upgrades dropping to five-to-one from highs of 12-to-one in the first quarter and 10-to-one in the second quarter. The improvement in the ratio of downgrades to upgrades was not the result of more upgrades, but fewer downgrades, fewer multi-notch downgrades and fewer fallen angels in the most recent quarter, Fitch analysts noted.
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