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This is for investment professionals only and should not be relied upon by private investors Downgrade risks when zombies become fallen angels Fidelity White Paper April 2020 Martin Dropkin Global Head of Research, Fixed Income George Watson Investment Writer

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Page 1: Downgrade risks when zombies become fallen angels…2 Fidelity White aper: Downgrade risks when zombies become fallen angels Fidelity nternational High yield braces for fallen angels

This is for investment professionals only and should not be relied upon by private investors

Downgrade risks when zombies become fallen angels

Fidelity White Paper

April 2020

Martin DropkinGlobal Head of Research, Fixed Income

George WatsonInvestment Writer

Page 2: Downgrade risks when zombies become fallen angels…2 Fidelity White aper: Downgrade risks when zombies become fallen angels Fidelity nternational High yield braces for fallen angels

2 Fideli ty InternationalFidelity White Paper: Downgrade risks when zombies become fallen angels

High yield braces for fallen angels The twin shocks to the global economy of the Covid-19

outbreak and the sharp oil price decline have resonated

through all asset classes. The high yield bond market must

now contend with a third potential shock - an influx of

downgraded investment grade bonds.

Last year, we released a paper about the rise of ‘zombie’

companies since the financial crisis - firms that show

little signs of life but manage to survive thanks to cheap

borrowing costs. At the time, many zombies were rated as

investment grade quality, although most were positioned

on the lowest rung in this category (BBB).

In The next recession: Zombie killer1, we argued that a

recession would be a necessary catalyst to shake some

zombies out of the system and free up resources for

companies that could use them more efficiently. With a

recession now upon us, many zombies are at risk of being

downgraded into high yield and becoming fallen angels.

This has significant implications for a global high yield

market already reeling from the abrupt economic downturn.

Fallen angels are attractive to high yield investorsUsually fallen angels find ready buyers in the high yield

market. Most fallen angels are asset rich companies

with some ability to generate financial flexibility. 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 - a highly desirable attribute in this crisis to

help avert liquidity stresses later in the year. Trading

liquidity is also much better in the bonds of fallen angels

than in those of smaller high yield issuers.

Historically, fallen angels tend to outperform when they

move to the high yield index, with the precise moment of the

second rating agency downgrade being the perfect time to

buy. However, there is reason to be cautious today, given the

amount of bonds at risk of a downgrade to high yield.

Index: C0A0. Source: Bloomberg, Fidelity International, April 2020.

Chart 1: The amount of US BBBs has ballooned since the financial crisis

AAA AA A BBB

Face

valu

e (U

SD tr

illio

n)

2010 20202005 20150tn

2tn

4tn

6tn

8tn

With a recession now upon us, many zombies are at risk of being downgraded into high yield and

becoming fallen angels.

1Link: https://www.fidelityinternational.com/article/the-next-recession-zombie-killer-d5d5ef-en5/

Page 3: Downgrade risks when zombies become fallen angels…2 Fidelity White aper: Downgrade risks when zombies become fallen angels Fidelity nternational High yield braces for fallen angels

The size of outstanding bonds at risk of downgrade is significantThe sheer size of the face value of bonds issued by firms

at risk of becoming fallen angels that will need to find

a home in the high yield market is a concern. Roughly

$215 billion of US debt and €100 billion of European

debt is expected to be downgraded to high yield this

year.2 The face value of bonds rated BBB has grown

steadily since the financial crisis and faster than the

high yield market. In the US, the amount of BBB3-rated

bonds outstanding now equals around 70 per cent of

the entire US high yield market.

In the last month, the difference between the spreads

of BBB and BB-rated bonds in the US corporate indices

has risen to 273 basis points. While this is not yet at the

extremes of the financial crisis, it is at a similar level to

previous economic slowdowns. This partially reflects the

overall performance of respective benchmarks, but we

believe the BB spreads are also anticipating an influx of

fallen angels into the HY index.

3 Fideli ty InternationalFidelity White Paper: Downgrade risks when zombies become fallen angels

IIndices: H0A1, C0A4. Source: Bloomberg, Fidelity International, April 2020.

Option-adjusted spread of C0A4 and H0A1. Source: Bloomberg, Fidelity International, April 2020.

Chart 2: The sheer size of potential fallen angels could overwhelm the US high yield market

Chart 3: US BBs underperform BBBs to price in arrival of fallen angels

HY BBB3 Proportion (RHS)

Face

valu

e ($

trill

ion)

Prop

ortio

n of

BBB

3 to

HY

2010 20202005 20150

0.6

1.2

1.8

2.4

0%

20%

40%

60%

80%

US BBB US BB Difference

2008 2012 2016 2020-1000

-500

0

500

1000

1500

2000

Basi

s poin

ts

To explain further, the possibility of a large amount of

debt moving into high yield could cause a crowding

out effect for the lower rated (B/CCC) companies in the

high yield index. Fallen angels, which will largely move

from BBB to BB, will swell the size of the BB category

in the index, forcing managers of both passive and

active strategies to reallocate from riskier categories

to maintain benchmark constraints. Fallen angels will

also have stronger balance sheets than lower-rated

companies, meaning they will find it easier to issue new

bonds, exacerbating this shift.

Index: HEC0. Source: Bloomberg, Fidelity International, April 2020.

Chart 4: Lower-rated European high yield firms at risk of being crowded out

Face

valu

e (E

UR m

illio

n)

BB B CCC2010 20202005 2015

0

50

100

150

200

250

2JP Morgan Credit Research, 23 March 2020.

Page 4: Downgrade risks when zombies become fallen angels…2 Fidelity White aper: Downgrade risks when zombies become fallen angels Fidelity nternational High yield braces for fallen angels

BBB spreads indicate some complacencyMany of the potential fallen angels’ bonds already trade

at spreads comparable to BB-rated bonds in anticipation

of a future ratings moves, so some of the impact of

downgrades is already priced in. However, our analysis

reveals that only around 5 per cent of the US investment

grade index is currently trading at spreads equal to or

wider than comparable BB-rated bonds. Considering

around 27 per cent of the index is rated as BBB2 or BBB3

- the categories most at risk of a downgrade to high

yield - this looks a little complacent considering the near-

instantaneous stop to economic activity in some sectors.

Navigating fallen angel riskAs we move through this crisis, more zombies will be

flushed out and market stresses will begin to dissipate. In

the meantime, a good way to navigate the heightened

downgrade risk is to run detailed liquidity and covenant

analysis on weaker companies to determine how long

they can survive without additional funding while access to

liquidity remains limited.

4 Fideli ty InternationalFidelity White Paper: Downgrade risks when zombies become fallen angels

Chart shows market weight of US investment grade bonds (C0A0 index) trading wider than Fidelity’s

BB quant curves. Source: Fidelity International, Bloomberg, April 2020.

Chart 5: Given the potential for downgrades, we would expect more US investment grade to be trading at high yield spreads

% M

ark

et w

eight

US investment grade bonds trading at BB spreads

2010 20202005 20150%

5%

10%

15%

20%

25%

Covenant analysis, looking for loopholes that could

be exploited by issuers, is especially important in a

downgrade cycle. Investment grade bonds are typically

issued with no covenants, meaning they are susceptible

to being ‘layered’ - when a company issues debt with

higher seniority, reducing the value of existing bonds - as a

company moves from investment grade to high yield.

A further worry for bond investors is the threat of leveraged

buyouts. Private equity firms are sitting on significant

amounts of capital that they are likely to deploy now that

valuations are more attractive. Existing bondholders almost

always lose out in leveraged buyouts as the business

model necessitates loading up target firms with freshly

issued debt.

Despite these risks, we believe investment grade bonds

are currently trading at very attractive levels, with

US bonds especially well positioned. Within the BBB

category, however, thorough research is needed to

understand those issuers most at risk from being moved

into high yield. At the higher quality end of the high yield

spectrum, spreads have reached attractive levels among

certain European names, but not so much in the US. A

high degree of caution is also necessary at the riskier

end of the high yield spectrum (CCC/B). Credit selection

here is paramount to identify those companies that, at

a minimum, do not need to tap the market for further

funding in the next six months.

A good way to navigate the heightened downgrade risk is to

run detailed liquidity and covenant analysis on weaker companies to

determine how long they can survive without additional funding.

Page 5: Downgrade risks when zombies become fallen angels…2 Fidelity White aper: Downgrade risks when zombies become fallen angels Fidelity nternational High yield braces for fallen angels

Below we outline which sectors are most at risk of downgrades, with the caveat that government support and economic conditions will vary depending on which stage of the crisis each country is at. In Asia, for example, fewer investment grade bonds currently appear to be at risk of a downgrade than elsewhere, but that could change if conditions worsen. 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.

EnergyThe energy sector is most at risk of downgrades, being at

the epicentre of both the oil glut and the demand shock

from Covid-19. Around $60 billion of investment grade debt

at the upstream end of the energy market has already

been downgraded to high yield, out of around $90 billion

at immediate risk. Despite the already sizeable numbers

involved, there is scope for more downgrades if the oil

price stays low.

The big issue is liquidity. While leverage is spiking for all

companies, it’s not high leverage that kills companies, it’s

lack of liquidity. Many of the issuers already downgraded

have bonds maturing this year. With little free cash flow

due to the low oil price, these companies face a near-term

liquidity strain just to roll over their existing debt.

The problem could continue into next year. Many

companies are well hedged against the oil price this year

5 Fideli ty InternationalFidelity White Paper: Downgrade risks when zombies become fallen angels

Sectors most at risk of downgrades

but not next year. And more companies have debt due

next year that could run into the same problems unless

market dynamics improve in the interim.

Additionally, credit ratings agency S&P has assumed an oil

price of around $45 next year in its models to asses energy

companies credit rating. Oil futures strips are currently

pricing oil at around $35 next year, and this mismatch could

lead to further downgrades if the oil price does not rise to

meet rating agencies’ assumptions.

AutosThe autos sector headed into the coronavirus outbreak

in a weak position, due to a softening cyclical backdrop,

trade tensions and margin pressures caused by stricter

environmental regulations and the need to invest in R&D.

Since the virus outbreak, ratings agencies’ base case

assumptions for global light vehicle sales have been revised

from flat to a fall of 15-20 per cent from last year. But there is

significant uncertainty around these estimates as the extent

of the damage will depend on how long plants are shut

down and consumers must stay at home. Rating agencies

have taken slightly different approaches: S&P has assigned

ratings according to their base case while Moody’s has put

most names on review for possible downgrade with the

intention to resolve the outlook within 90 days.

Ford recently became the largest ever fallen angel as a

direct result of the current crisis. Several more issuers in

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6 Fideli ty InternationalFidelity White Paper: Downgrade risks when zombies become fallen angels

the sector are at risk of crossing into high yield, and the

aggregate face value of downgrades could be large if

S&P becomes more aggressive with its rating actions.

Aircraft leasingThe aircraft leasing sector (excluding Chinese lessors) is

at high risk of downgrades to high yield during this cycle.

While many firms have relatively strong liquidity positions

to cover expected debt maturities and capex commitments

this year, there are several challenges facing the sector.

It is highly likely that all airlines will ask lessors for

deferrals on lease payments as they struggle for liquidity

while their fleets remain firmly on airport tarmacs. This

will impact cashflow for lessors who will have to decide

which airlines to support. Airline defaults are likely to rise,

resulting in lessors being returned aircraft with limited, if

any, re-leasing options. On top of this, lessors may have

to take impairment charges on the value of their aircraft,

which would directly impact debt-to-equity ratios.

Furthermore, lessors are wholesale funded, so must

continuously refinance their maturing bonds, and it’s likely

that none of the lessors will have access to unsecured

bond markets for the foreseeable future. Lessors will

therefore have no choice but to repay maturing debt from

cash and undrawn facilities (reducing liquidity headroom)

or to tap secured funding lines which would increase

debt encumbrance and directly subordinate unsecured

bondholders. Secured debt as a percentage of tangible

assets is a key metric that ratings agencies use, further

increasing the risk of downgrades.

AirportsUnsurprisingly, airports are struggling in the current

climate. In the past, downturns meant lower revenues but

not the total shutdown of air traffic. Airports are large

fixed cost businesses and are now generating significant

negative free cash flow. The path to the normalization of

travel is also uncertain due to the impending steep fall in

economic growth as well as travel restrictions.

On top of the operating challenges, many airports have put

in place highly complex debt structures with high leverage.

The covenant ‘protections’ that were there for investors to

compensate for higher leverage have now rendered airport

financing structures too inflexible to deal with the current

conditions. As a result, many of these structures are in

precarious positions and the risk of downgrades to high yield

is much higher than it has ever been.

Mineral and mining The investment grade metals and mining sector is now

considerably better placed than it was going into the

previous commodity down cycle of 2015-2016. Large cap

diversified mining companies have reduced their absolute

net debt levels by as much as 50 per cent or more since

then, and net leverage ratios are close to or below 1x,

having peaked in 2015 in many cases above 4x.

Levels of liquidity have been bolstered and average debt

maturities have been lengthened, reducing the need for

near-term funding. Hence, while the impact on earnings

and cashflow will be significant again, the impact on

credit ratings should be less severe than in 2016. Miners

often operate in emerging market countries where

exchange rates have depreciated significantly. This helps

those companies as revenues are in dollars and a large

proportion of costs are in local currencies.

Retail Retail in the time of coronavirus is a tale of two groups.

Food and essential retailers will do just fine. Demand

has spiked from stockpiling and the switch to ‘at home’

Ford recently became the largest ever fallen angel as a direct result

of the current crisis.

Page 7: Downgrade risks when zombies become fallen angels…2 Fidelity White aper: Downgrade risks when zombies become fallen angels Fidelity nternational High yield braces for fallen angels

preparation and consumption patterns. Food retailers will

be among the clear winners and there is no downgrade

pressure in the sector as a result of the virus outbreak.

Discretionary retail, however, is under heavy pressure

from mandated closures under lockdown. Aside from

e-commerce, there is no revenue coming into many

companies during this time, and even e-commerce is liable

to logistics disruption due to employee health concerns.

A prolonged lockdown of 1-2 quarters means discretionary

retailers will be relying largely on existing liquidity (cash,

credit facilities, supplier/vendor support) and their ability

to manage, cut or defer fixed costs. This has led to large

employee furloughs by retailers, only some of which are

offset by government support, rent deferrals, cancelled

orders, refusal to accept shipments, senior management

salary cuts and dividend and share repurchase

suspension.

Given the focus on basic liquidity for survival, rating

agencies have been very active in the retail sector with

notable downgrades to high yield for several companies

already. Many other mid-low BBB retail credits are also at

risk of further downgrades if lockdowns are extended.

Beverage and food distributionMany restaurants, bars and cinemas are closing as

governments around the world enforce social distancing

policies. Data from Open Table indicates that global

bookings are down 100 per cent in most geographies

tracked since mid-March. Fast food may fare slightly better,

but recent data still indicates declines.

This demand shock doesn’t just hurt restaurants, but also

their suppliers, including many beverage companies and

7 Fideli ty InternationalFidelity White Paper: Downgrade risks when zombies become fallen angels

Data from Open Table indicates that global bookings are down 100 per cent in most geographies tracked

since mid-March.

food distributors. Beverage companies, particularly

those with large emerging markets exposure, are likely

to face challenges even in their off-trade (retail sales)

as the economic impact of Covid-19 will hit discretionary

spending. Many of the beverage companies and

food distributors had levered up in recent years to

fund acquisitions and they may find themselves poorly

positioned within the investment grade ratings category

to manage this incremental shock.

Leverage remains high among some US and European

food companies, even though headlines indicate these

companies have benefitted from consumer hoarding.

To be fair, some issuers have done what they said they

would do and deleveraged prior to this downturn, and

some of the risk has already moved to high yield. Our

base case is that most packaged food companies

should remain investment grade, but leverage remains

high in the BBB segment and there is some risk.

Leisure and gamingThe investment grade downgrade risk in leisure

and gaming varies considerably by sector. Lodging

companies and online travel agents have generally

moved to an asset-light model meaning that they are

far less exposed to the current downturn than they were

in past cycles. Therefore, only those that were already

weakly positioned within the investment grade category

should see downgrade pressure.

In contrast, the cruise industry is asset heavy and,

therefore, faces far greater downgrade risk. Operating

leverage plus significant negative working capital

outflows have dramatically changed balance sheet and

liquidity positions and we believe high yield downgrades

are very likely.

The risks of rating changes at the few gaming

companies with an investment grade rating are mostly

idiosyncratic. Generally, we view the risk as being higher

in the gaming REITs. For operators, only the highest

quality and most conservatively financed companies

had an investment grade rating, leaving these operators

better positioned to manage through industry turbulence

than most of their peers.

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