Janus Henderson Investors: Recent fallen angels — a spectre of BBB downgrades to come?

Kraft Heinz is now the largest ever fallen angel in the developed markets, adding around $23bn of bonds into the high yield sector.

Tom Ross, corporate credit portfolio manager, shares his thoughts on the downgrades and explains that the current picture is somewhat less ugly than that painted by the media.

Key takeaways:

• Fears of a surge in supply into the high yield market may be somewhat overdone. While there have been a number of BBB downgrades into high yield this year, they have not had a major impact on the broader markets.
• Rising stars (high yield names moving up into investment grade) are still outpacing fallen angels and positive technical factors in the US, such as the tie‑up between Sprint and T‑Mobile, which tightened Sprint spreads, has effectively driven extra demand for other US high yield bonds.
• Are the recent fallen angels the start of a new trend? We believe not. While there are a handful of names to look out for in the near future, the low volume of BBB bonds that are on downgrade watch in the US, do not indicate a sudden significant wave of downgrades into the high yield market.

Video summary

Background to recent headlines

The topic of fallen angels has been hotly discussed over the last 12 to 18 months, with big fears around the rise of the BBB market and the size of the BBB market in both the US and also in Europe.

We’ve started to see some of those fallen angels start to occur, and there has been some large, fairly well-known, names that would have caught the media headlines recently. The most notable name is Kraft Heinz. This is the second largest fallen angel ever, and the largest within the developed markets, with Petrobras previously being the largest on a global basis. There is now a big transition of those bonds from the investment grade market into the high yield market.

Given this has been such a huge concern for clients, we thought we would give an update on our thoughts on what is going on at the moment. Because it is not just Kraft Heinz, we also have the potential for Renault SA, which may or may not, but there is a good chance that also starts entering into the high yield indices at the start of this [coming] month.

We have also had downgrades to companies like Macy’s, so that is another potential fallen angel. And earlier on this year we also had the Atlantia (Autostrade) situation, following the potential for their concessions business of the toll roads being revocated, which has also led to a downgrade into the high yield market.

A look behind the headlines

What we want to stress though, is what we are really seeing within the market. Because in fact we have not seen a huge amount of impact on the broader market from these. When we start looking a little bit closer, it is still the case that rising stars — those companies transitioning from high yield to investment grade — are still outpacing the fallen angels, the companies going from investment grade to high yield. The technical in that respect, that potential for extreme, extra supply, into the high yield market, at the moment is still not overwhelming and in fact is going the other way.

Seeing a positive technical situation in US high yield

In addition we have had another positive technical situation within the US high yield market, where the tie‑up between Sprint and T‑Mobile has meant that a large risk name, in Sprint, in the US high yield market, has tightened significantly in spread and is now effectively a lower risk credit, and that effectively has also driven extra demand for other high yield bonds for US high yield investors. So, when you couple this to the rising stars that are still outpacing fallen angels, that leads to the market still being fairly well technically supported.

Will there be a sudden wave of downgrades into high yield?

The question going forward is how many more fallen angels? Is this the start of a trend of more fallen angels coming down into the high yield market? At the moment, there are a handful of names we need to watch very closely.

Ford would be a very large one, and another downgrade would signify a big fallen angel there. We have already mentioned Macy’s as a potential for a fallen angel. But when we actually look at the proportion of the BBB market within the US that is on downgrade watch from a low BBB rating, those volumes are relatively low at the moment. So, we don’t think that this is suddenly the start of a significant wave of downgrades into the high yield market.

Strategy in portfolios in the wake of recent fallen angels?

So, what have we been doing within portfolios in the wake of these fallen angels? We have to start being very selective and looking at the individual situations and see whether they propose an opportunity within the high yield market.

For a name like Kraft Heinz, which has decided not to keep its investment grade rating through cutting its dividends, we still believe that the business model there is going to be very sustainable into the future, even for a large amount of those long‑dated bonds, those 30‑year bonds that they have within the market.

And then if we look at some of the other examples, if we took a company like Renault, and it’s the operating part of the company there that potentially might get downgraded into the high yield indices, that is in a trickier spot in our opinion. The auto industry is going through severe disruption, trying to transition from petrol and diesel cars into electric, and for Renault that is very much focused on the smaller cars, it is much harder to maintain margins that are already fairly low on the small car part of the market, when they move into electric vehicles.

So, again, from the fundamental perspective, not really looking at Renault SA as an opportunity for a fallen angel, whereas in something like Kraft Heinz, we do see as an opportunity.

Note:

Reference to individual companies, or any securities is purely for the purpose of information only and should not be construed as a recommendation to buy or sell the same.