Those fears proved overblown. The onset of the pandemic initially produced fallen angels at an unprecedented pace. During the first seven months of 2020, the S&P Global Ratings credit-rating agency downgraded 40 issuers of a collective $340 billion in debt to junk status globally, including big companies such as Occidental Petroleum, Kraft Heinz, Carnival, Delta Air Lines, Renault, and Ford. However, the major dislocation anticipated by the markets pre-pandemic didn't materialize.
This recession was also unusual in being largely caused by efforts to rein in a health crisis, not by more typical culprits such as an overheating economy, a bursting asset bubble, or an unexpected external shock. Sectors that are more sensitive to travel restrictions and other social-distancing measures—such as transportation, leisure, hospitality, and retail—were hit much harder than in other downturns and produced a larger proportion of fallen angels.
In other ways, however, the latest recession has played out better than might have been expected. Unlike during the global financial crisis, many governments and central banks provided swift and unprecedented support to help lessen the pandemic's blow by injecting liquidity into some of the most affected sectors. In the United States, for example, Congress provided three rounds of grants and loans totaling nearly $80 billion to airlines; regulators showed flexibility in airport slot usage and lease payments on toll roads; and the Federal Reserve made investment-grade bonds eligible for its asset-purchase program and set up several corporate credit facilities to provide a financing backstop that helped stabilize the market and support a swift recovery in bond spreads.
Credit-rating agencies responded positively to these developments and to a surprisingly fast recovery in corporate earnings overall. We have seen multiple positive rating actions this year from rating agencies. The fallen angel ArcelorMittal, for example, recently completed a round trip back to investment grade in just a little over a year.
"In this environment, we were able to add significant value with crossovers," said Min Fang, a U.S.-based Vanguard credit analyst. "We held on to some fallen angels that were fundamentally solid, which limited the potential loss from fire sales and resulted in outsized returns when those companies began to recover. We also provided liquidity to some corporations that were expected to recover over time—including airlines, cruise lines, and hotels—by purchasing new debt issued during the pandemic at very attractive levels."
Where crossover opportunities stand now
Historically, the ideal time to invest in fallen angels has been immediately after a downgrade to high yield. That's because often most of the bad news has typically been priced in by the time of the downgrade. Since another wave of downgrades is unlikely at this point in the credit cycle, active managers still have the opportunity to try to add value by identifying potential rising stars well ahead of their being upgraded to investment-grade.
By sector, prospects too have shifted. For industries and companies that were facing long term decline before the pandemic, business conditions could deteriorate further. For example, nonessential brick-and-mortar retailers are likely to face more difficulties as online shopping has accelerated in popularity during the pandemic. As a result, some fallen angels in those industries may remain in high-yield territory.
On the other hand, although some hard-hit industries such as airlines, hospitality, and leisure may see some structural damage to long-term demand for business travel, new demand spurred by global economic growth could provide some offsets. Fallen angels in these industries should recover over time to pre-COVID levels, enabling them to migrate back to investment grade.
And industries that are well-positioned to benefit from new trends emerging in the post-COVID world—including digitization, remote working, and supply-chain reconfiguration—may also see benefits to profitability and thus potentially more rising stars.
"The opportunity set within the crossover universe has narrowed as the global economy recovers from the recession, and the spreads of risk assets have meaningfully tightened over the past 12 months," said Bradley Marr, a U.S.-based Vanguard senior high-yield credit analyst.
"We still have a number of avenues at our disposal, though, to add value: by avoiding fallen angels, as they can experience severe price declines; by taking advantage of market inefficiencies, whereby investing in these fallen angels has proven to provide attractive risk-adjusted returns; and by identifying rising stars, to take advantage of their potential for price appreciation in the event of an upgrade to investment grade."
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