Industry Voice: Finding the most investable fallen angel bonds in high yield

Fallen angels,  or bonds downgraded from investment grade (IG) to high yield, offer strong, risk-adjusted return potential. As funding costs rise, we expect fallen angel supply to increase, but not all fallen angels offer the same opportunity for outperformance. How do we differentiate those with the best potential?

We believe tighter lending conditions will inevitably impact already weakening credit fundamentals. The resulting increase in ratings drift for corporate bonds will ultimately lead to a rise in fallen angels. That creates an opportunity for credit investors - one that is best exploited using an in-depth knowledge of the market and a bottom-up approach, in our view. Here we offer insights into the many triggers that can cause a bond's rating to fall and how we distinguish fallen angels that are fit for investment from falling knives which could continue to deteriorate both in rating and performance.

Three golden rules of fallen angel behaviour

 Before looking at some of the triggers that lead to bonds being downgraded and leaving the IG index, it's helpful to keep in mind three key points:

1. Fallen angels fall for a reason:  Fundamentally, the credit has deteriorated, so it is vital to understand the reasons why. Is the company still sound and able to operate effectively as a BB-rated business? In which case the bond's performance should stabilise and recover over time. Or is the downgrade a sign of more profound issues from which the firm may never recover?
2. Financial metrics are only part of the story: Fallen angels descend because their credit metrics are no longer commensurate with an IG rating. However, financial metrics are backward-looking, and are always a function of the company's business profile: the environment in which it is operating, its management, strategy, financial policy and other factors
3. Downgrades can be accidental or intentional: While a company's credit rating usually falls ‘accidentally', in certain circumstances it can also be allowed to fall on purpose. It is therefore important to understand whether the downgrade is the consequence of external pressures - or the result of a choice made by the business for a reason.

"It is important to remember that a fallen-angel strategy is not about identifying future rising stars that will return to investment grade. Instead, it aims to exploit the market's short-term, negative overreaction in the pricing of downgraded bonds."

To do so, quantitative and qualitative analysis is needed to select investable fallen angels and exclude falling knives.

Understanding deliberate downgrades

 It may seem counterintuitive for a company to deliberately allow its credit rating to fall. However, this can happen for two key reasons:

1. A change in financial policy: In certain circumstances, a company may choose not to adhere to the IG criteria set by a ratings agency. For example, to maintain a BBB- rating, the ratings agency may require a company to have net EBITDA of above 3x; the company may find this too demanding and consider an EBITDA of 4x perfectly feasible and may accept a downgrade to BB. Nothing has changed from an operational perspective, so if the company is able to fund itself effectively despite paying more for its debt, there may not be a significant issue.
2. Increasing leverage for a major acquisition: A firm may accept a downgrade to high yield when its financial metrics are impacted by taking over another business. Often the company's stated aim will be to return to their previous rating within two to three years, either via asset sales or by deleveraging through cashflow. In this scenario it is necessary to consider the execution risk involved in making the acquisition and integrating the acquired business.

The reasons for ‘accidental' downgrades

Accidental downgrades fall into one of two main categories: either they relate to the company's business profile, or they result from a significant one-off shock to the company.

Business Profile

For example, turbine maker Bilfinger^[1] failed to adapt quickly enough to lower demand for its products as big utilities companies progressively reduced capex. Having issued multiple profit warnings, its rating eventually fell several notches. However, post-downgrade, the firm reduced its cost base and right-sized its operations to operate effectively at BB grade, as a market still existed for its products. In contrast, video rental company, Blockbuster1 failed to adapt as videos and DVDs were replaced by streaming - most significantly perhaps by not buying Netflix as a start-up. As a result, the downgraded business went into terminal decline.

One-off shocks

The consequences of these shocks can be financial, operational and/or political. For example, Brazilian metals and mining company Vale1 was responsible for two fatal dam collapses in the space of four years. The company's bonds were downgraded to high yield in the wake of the disaster, but its strong profile as one of the world's biggest iron ore and nickel producers means its ratings have since recovered. Our analysis of ESG business practices led us to believe that Vale had not learned from these tragic events, however, and we did not invest - and still consider the firm to be highly controversial. This shows another benefit of an active approach to investing in fallen angels: the ability to integrate qualitative ESG and sustainability insights.

The infamous Enron serves as an example of a one-off shock that turns a firm into a falling knife. The energy company's downgrade, following the discovery of  a huge accounting scandal was effectively a one-way ticket to bankruptcy. Finally, a less common issue to be aware of is a large, investment-grade business being acquired by a smaller, high-yield company. However, most investment-grade businesses now have a ‘change of control' clause.

Understanding the impact

Whatever the cause of a downgrade, the key to identifying a fallen angel is understanding the longer-term impact of the change in rating. To do this, investors can ask three key questions:

1. Is the situation as significant as the market judges it to be? For example, while the reputational impact of an incident may be severe, this is usually of less importance to a non-consumer-facing business, particularly one which is dominant in its sector.
2. Are the problems endemic or do they amount to a one-off issue? Covid is a good example that created severe one-off issues for businesses such as cruise liners. However, because the setback was ultimately temporary and the underlying business models were extremely strong, many companies withstood a shutdown of operations. With bookings now even higher than before the pandemic, we expect their ratings to recover.
3. Can the issues be fixed? The threat of litigation or even the shutting down of operations may look fatal for a business, however, this risk is usually resolved by paying a fine or compensation. If the company takes corrective action, the outcome may ultimately be positive. Volkswagen¹ after Dieselgate is an example of where improving procedures and/or changing a business model has made a company stronger.

Why active management matters

An effective fallen-angels strategy should always be based on an active approach, in our view. Quantitative analysis of fundamentals is necessary to understand the financial robustness of a company, while qualitative analysis is vital to understand the circumstances of a downgrade, and thus its likely longer term consequences.

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This post is funded by Lombard Odier Investment Managers 

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