A wave of “fallen angel” bonds – those issued by investment-grade companies that have since been downgraded to junk status – has started to break amid the coronavirus outbreak, and more are expected in the coming months.
The impact will be painful for institutional investors, especially insurance firms, though they can take action to soften the blow, say experts.
A key issue is that far more bonds are now sitting in the lowest tier of invest-grade ratings than a decade ago. As of October 2019 the proportion of BBB bonds in the global investment-grade market had inflated to $2.5 trillion, or around 50% of outstanding debt, according to analysis of the Bloomberg Barclays Global Aggregate Corporate Total Return Index by Vanguard.
Roughly $215 billion of US debt and €100 billion ($109.36 billion) of European debt is expected to be downgraded to high yield this year, noted fund house Fidelity in a paper published on April 9, citing JP Morgan research.
In Asia, fewer investment-grade bonds appear at risk, but that could change if conditions worsen, the report added. "Some companies will also be affected by any changes to sovereign ratings, for example, state-owned corporates and banks in countries such as Indonesia and India."
Measures that investors are now seen undertaking or considering to mitigate the risks include relaxing guidelines on the permitted holding period of lower-grade debt and pre-emptively de-risking fixed income portfolios.
Kevin Jeffrey, director of investments for Asia at consultancy Willis Towers Watson, said he had seen investors extend the period within which their managers are obligated to sell bonds that have had their ratings cut from investment-grade to high-yield.
For example, portfolio managers may now have two to three months, instead of one, to exit a below-investment-grade position and find a replacement, he told AsianInvestor.
“[On] certain days [bonds] were very difficult and expensive to trade, so we have seen some of the more sophisticated investors relaxing guidelines because of the extreme environment,” Jeffrey said.
Moreover, while experts say they haven’t seen much forced selling yet, some argue that investors would do well to be proactive and stay ahead of the rating agencies.
“Insurance companies and pension funds can try to get ahead of this analysis, looking at their own positioning, where their vulnerability is, and can be proactive and take actions [to de-risk their portfolios],” said Jim Veneau, Hong Kong-based head of Asia fixed income at Axa Investment Managers.
Insurance firms look particularly susceptible to any losses sparked by downgrades, wherever their holdings are geographically.
“Insurers hold a lot more fixed income than your average pension or most other private asset owners, so the potential impact from credit events or downgrades will be higher for them than other asset owners,” Jeffrey noted.
A report by consultancy Milliman in March 2018 showed that Hong Kong insurers held 57% of their portfolios in fixed income, with 28% of their bond exposure rated between BBB+ and BBB-, just slightly above junk level.
While losses from defaults or forced rebalancing won’t be as dire as those from equities, which have also seen big selloffs, a 5% to 10% loss on investment-grade instruments is possible, he added. “That'd be a pretty bad outcome."
What's more, in many jurisdictions there are now tighter regimes governing how much investment risk that the likes of insurers and pension funds can take.
Historically, insurers would not go into junk bonds, Jeffrey said. The high risk charges that regulators have slapped on high yield under new risk-based capital (RBC) rules have also deterred investors from holding those assets.
For example, for insurers under Singapore's RBC 2 regime, the default risk charge of BBB- to BBB+ bonds stands at 5%, but it rises to 10.5% for BB- to BB+ rated bonds. Such charges can go as high as 48.5% for bonds that are rated at CCC+ and below.
While the yield spread for junk bonds has surged, Axa IM's Veneau said the yield offset was generally not sufficient to cover the higher capital incurred by the lower credit rating. Spreads on BB debt, the highest tier of junk bonds, soared to 8.37% on March 23, and closed at 5.57% on April 10, according to the ICE BofA BB US High Yield Index. Before mid-March the index's highest spread over the previous five years had been 5.82% on February 11, 2016.
“Fallen angel credit spreads widen and prices drop, but [those bonds] are still relatively low-yielding compared to other high-yield names,” Veneau noted.
There can be good reasons for this.
"Most fallen angels are asset-rich companies with some ability to generate financial flexibility," the Fidelity report said. "Passive investors will be compelled to buy them. For active investors, fallen angels represent credits that often have better access to capital than smaller, more levered companies."
Moreover, fallen angels' bonds also tend to offer lower liquidity than those of smaller high yield issuers, it added, and they tend to outperform when they drop into the high yield index.
"However," Fidelity warned, "there is reason to be cautious today, given the amount of bonds at risk of a downgrade to high yield."
Joe Marsh contributed to this story.