Bond Investors Prepare for ‘Fallen Angels’ | Fund managers
A wave of ‘fallen angel’ bonds – those issued by good quality companies that have since been demoted to junk status – started to break amid the coronavirus outbreak, and more are expected in the coming months.
The impact will be painful for institutional investors, especially insurance companies, although they can take steps to soften the blow, experts say.
A key problem is that many more bonds are now in the lowest level of investment ratings than ten years ago. By October 2019, the proportion of BBB bonds in the global investment grade market had swelled to $ 2.5 trillion, or about 50% of outstanding debt, according to the analysis Vanguard’s Bloomberg Barclays Global Aggregate Corporate Total Return Index.
About $ 215 billion in US debt and 100 billion euros ($ 109.36 billion) in European debt are expected to be downgraded to high yield this year, fund house Fidelity noted in an April 9 article, citing a study by JP Morgan.
In Asia, fewer quality bonds appear threatened, but that could change if conditions worsen, the report adds. “Some companies will also be affected by any change in sovereign rating, for example, state-owned companies and banks in countries like Indonesia and India.”
Willis Towers Watson
Steps investors are now taking or are considering taking to mitigate risk include relaxing guidelines on how long low-grade debt securities are allowed to hold and pre-emptively reducing risk for fixed income portfolios.
Kevin Jeffrey, chief investment officer for Asia at consultancy firm Willis Towers Watson, said he has seen investors extend the period during which their managers are forced to sell bonds that have been downgraded from the category. investment to the high yield one.
For example, portfolio managers can now have two to three months, instead of one, to exit a position below investment grade and find a replacement, he said. AsianInvestor.
“[On] some days [bonds] were very difficult and expensive to trade, so we saw some of the more sophisticated investors relax their guidelines due to the extreme environment, ”Jeffrey said.
Plus, while experts say they haven’t seen many hard sells yet, some argue investors would do well to be proactive and stay ahead of rating agencies.
“Insurance companies and pension funds can try to get ahead of this analysis, looking at their own positioning, where their vulnerability is, and can be proactive and take action. [to de-risk their portfolios]”said Jim Veneau, head of fixed income for Asia based in Hong Kong at Axa Investment Managers.
Insurance companies seem particularly sensitive to losses caused by downgrades, wherever their assets are geographically located.
“Insurers hold much more fixed income than your average pension or most other private asset owners, so the potential impact of credit events or downgrades will be greater for them than for other owners of assets. assets, ”noted Jeffrey.
Axa Investment Managers
A report by consultancy firm Milliman in March 2018 showed that Hong Kong insurers held 57% of their portfolios in fixed income, with 28% of their bond exposure rated between BBB + and BBB-, slightly above the level. junk.
While losses from defaults or forced rebalancing will not be as severe as those from stocks, which have also seen big sales, a 5% to 10% loss on quality instruments is possible, he said. added. “It would be a very bad result.”
In addition, in many jurisdictions there are now more stringent regimes governing the level of investment risk that insurers and pension funds can take.
Historically, insurers weren’t going into junk bonds, Jeffrey said. The high risk fees that regulators have imposed on the high yield under the new venture capital (RBC) rules have also deterred investors from owning these assets.
For example, for insurers under Singapore’s RBC 2 regime, the default risk load for BBB- to BBB + bonds amounts to 5%, but increases to 10.5% for bonds rated BB- to BB +. These fees can go up to 48.5% for bonds rated CCC + and below.
As the yield spread for junk bonds increased, Veneau of Axa IM said the yield compensation was generally not enough to cover the higher principal incurred by the lower credit rating. Spreads on BB debt, the highest level of junk bonds, climbed to 8.37% on March 23 and closed at 5.57% on April 10. according to ICE BofA BB US High Yield Index. Before mid-March, the index’s highest deviation over the previous five years was 5.82% on February 11, 2016.
“Angel investor credit spreads are widening and prices are falling, but [those bonds] still have a relatively low yield compared to other high yielding names, ”noted Veneau.
There may be good reasons for this.
“Most fallen angels are asset-rich companies with some ability to generate financial flexibility,” the Fidelity report said. “Passive investors will be forced to buy them. For active investors, fallen angels represent credits that often have better access to capital than smaller, more indebted companies.”
Additionally, fallen angel bonds also tend to offer lower liquidity than those of smaller, high-yielding issuers, he added, and they tend to outperform when they fall into the high-yield index. .
“However,” Fidelity warned, “there is reason to be cautious today, given the number of bonds at risk of being downgraded to high yield bonds.”
Joe Marsh contributed to this story.