The current credit cycle suggests upgraded ratings are ahead for many high-yield corporate bonds. Find out what’s behind the brighter outlook.
Like equity investors, bondholders can see a position substantially rise or fall in value when an issuer is added to or removed from an index. Updates to the constituents of an equity index tend to be infrequent and due solely to company-specific factors. On the other hand, bond indexes rebalance monthly and can experience waves of inclusions or exclusions as the credit cycle ebbs and flows.
A favorable economic outlook, along with an ensuing upgrade trend, may provide risk-tolerant ladder investors a way to enhance yields and improve returns during this period of historically low interest rates and credit spreads. Let’s look at the advantages that accrue to the holder of a bond upgraded from high yield (HY) into the investment-grade (IG) universe.
The challenges of credit analysis versus equity analysis
While I was training as a credit analyst in the late 1980s, my mentor emphasized that although our process for analyzing a company mirrored that of our equity counterparts, the two roles had very different objectives. Since bonds are issued at par and mature at par, she contended that a credit analyst’s primary goal was to determine if a company would generate sufficient free cash flow over the life of the bond to cover its interest expense. She noted that coupon payments accounted for the vast majority of a bond’s total return, which is still the case today. Even though interest rates have steadily declined since the inception of the ICE BofA 1–10 Year US Corporate Index in 1983, coupon income has been responsible for 95% of its 7.2% annual return since inception.
In contrast, my mentor thought equity analysts faced the additional complexity of needing to anticipate the actions of other investors, much like that of a fashion designer charged with spotting the next trend that will drive demand and prices. She was quick to mention one important caveat: Since a credit upgrade or downgrade that moves a bond between IG and HY indexes can generate a large price swing, credit analysts must also assess the possible action of rating agencies when analyzing a security on the cusp of changing sectors.
How do fallen angels become rising stars?
The corporate bond market can be divided into two sectors, IG and HY, depending on an issuer’s credit ratings. Bonds included in an IG index carry a credit rating of AAA, AA, A, or BBB, while those assigned to a HY index fall into the lower ratings categories of BB, B, and CCC. In general, companies with high leverage in a given industry are more at risk of experiencing a credit issue and therefore receive a rating below IG. To compensate for this additional risk, investors require higher coupon rates and more restrictive covenants. Investors have historically been more than adequately compensated for taking credit risk, with the ICE BofA 1–10 Year BBB US Corporate Index and the ICE BofA 1–10 Year BB US High Yield Index each outperforming US Treasury notes of the same durations by 1.26% and 2.26%, respectively, since 1996 (the first year that excess return data became available).
As an issuer’s business prospects rise and fall, the ratings agencies constantly reevaluate where in the ratings universe it belongs. In the investment industry, bonds upgraded from HY to IG are known as rising stars, and bonds downgraded from IG to HY are known as fallen angels. Owning a fallen angel as it migrates from IG to HY can be costly to performance, especially if an account is required to sell a bond if the issuer fails to maintain their IG rating, which is a common guideline of many IG mandates. In practical terms, a downgrade below the lowest IG rating of BBB can result in widespread forced selling that pushes prices lower, creating a significant underperformance relative to the rest of the IG market.
In contrast, most investment guidelines don’t require managers to buy rising stars. But if they fail to do so, they introduce tracking error into the portfolio, particularly if the upgraded company is a large issuer. Since these upgraded bonds tend to outperform relative to the rest of the IG market, the manager risks underperforming the index and their peers. Owning an HY security that gets upgraded to IG can create a significant performance advantage.
By the end of 2020, credit markets had fully recovered from the pandemic-triggered economic collapse earlier in the year. Even though it’s been just a little over a year since corporate bond prices troughed in March 2020, we believe credit markets are already in the middle stages of the recovery portion of this cycle. Historically these periods last several years and coincide with improvement in economic activity. During this phase of the cycle, upgrades outpace downgrades, rising stars outnumber fallen angels, and defaults decline as the rising tide of economic improvement bolsters most corporate balance sheets.
A record number of domestic bonds were downgraded from IG to HY in 2020, causing a dramatic increase in the ratio of fallen angels to rising stars. As the recovery cycle progresses, we expect many of the companies that were downgraded to HY to make their way back to IG in order to reduce financing costs and improve their operating flexibility. This would be consistent with historical experience; according to Moody’s, approximately 25% of fallen angels regain their IG rating.
Other factors should help sustain an extended upgrade cycle. Since issuers with IG ratings have lower borrowing costs and better access to global capital markets, HY company managers are incentivized to improve their credit ratings. Many companies use the higher earnings associated with an economic recovery to delever their balance sheets and improve their credit status. We’re already seeing this phenomenon in the companies we regularly analyze. The A-rated bond sector is one area where this isn’t occurring, but we think this is largely due to the growing confidence of management teams that the current economic expansion has staying power. This confidence has driven a surge in acquisitions, increasing leverage ratios and fueling a number of downgrades. Given the context, we don’t view this as a bad thing.
Recent improvement in the ratio of upgrades to downgrades supports the view that the cycle has turned to recovery. This year there have been 13 US rising stars totaling $18 billion and only two fallen angels totaling just $1.2 billion. It’s also encouraging that May marked the third consecutive month that produced no fallen angels. Furthermore, HY upgrades have doubled the pace of downgrades each month this year. Despite this improvement and BBB-rated bond spreads setting post–credit crisis lows of 90 basis points (bps), BB-rated bond spreads have only tightened to 220 bps, remaining well above their postcrisis tight of 175 bps.
The bottom line
We believe credit markets are entering a multiyear upgrade cycle. Repeated rounds of monetary and fiscal stimulus have created plentiful liquidity that should continue to contribute to the economic expansion, increasing earnings while improving balance sheets and wage prospects across the economy. Against this backdrop, we’d expect to see more rising stars, which could help mitigate the impact of higher interest rates.
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