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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 DropkinGlobal Head of Research, Fixed Income
George WatsonInvestment Writer
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/
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.
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.
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
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.
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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