Taking flight

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A raft of recent US investment grade bond downgrades amid waves of market volatility is creating a potentially ripe area of investment for so-called fallen angels. In a special Q&A with Mellon senior portfolio manager Manuel Hayes we ask: can this trend be sustained and what are its key drivers?

Q: How do you view the opportunity within fixed income at present?

MH: When we look at the market, and the corporate landscape in particular, the one shining star we see throughout the entire spectrum has to be fallen angels¹. From both a macro point of view and from the technical side of things we’re optimistic.

And there’s good reason for that: Against a very difficult backdrop for fixed income investors, 2020 was a great time for the asset class. We saw record levels of downgrades; 50 companies across US$200bn of bonds. It might sound strange to be positive about downgrades but the opportunity within fallen angels is set up in such a way that downgrades can provide an extremely attractive entry point for investors if they can harvest that universe in a systematic way.

Q: What’s your outlook on defaults/downgrades from here?

MH: We believe the pace of downgrades continues going into 2021. For one thing, we still have that triple-B bloat where you can see a large number of bonds hovering just above that downgrade threshold – more than US$900bn in the triple B-minus segment alone.

Given the pandemic and fundamental concerns around the number of highly leveraged, low profitability issuers, we believe it’s just a matter of time before we see further waves of downgrades. For investors in fallen angels that equates to some consistent opportunities to buy attractively valued bonds, as we saw last year.

Q: Can you describe some of the market inefficiencies that make fallen angels an attractive asset class?

MH: If you consider the fixed income corporate universe as a whole you generally have a bifurcated market, investment grade managers and high yield managers – and there’s really not much crossover. That means that when a bond gets downgraded and crosses over the threshold into the high yield universe you have a whole cohort of investors–think index managers, for example–who can no longer own that bond. They become forced sellers and the bond automatically trades at a discount regardless of its underlying value. That’s why it’s an inefficient market and it’s that structural premium that can make fallen angels such an attractive segment of the credit universe.

Q: Do you have any concerns around the current direction of the market?

MH: We always have to do our due diligence – and need to be ever more aware of what we’re buying. The situation we have right now is one where global central banks have been pumping liquidity into the system and artificially inflating everything – even though the economic fundamentals are nowhere near as good as they were in 2019. So that means there’s greater potential for so-called ‘zombie’ companies to rise unchecked through the market.

So the onus is on investors to really drill down to identify these lower quality companies which are raising their leverage metrics higher than some should. Clearly, there’s a follow-on question to this: what about defaults? Here we’re relatively sanguine: We believe there will be defaults but likely less than in 2020 where for the most part they were concentrated in the energy, retail and to a lesser extent the retail sectors.

¹ Fallen angels are bonds that have been downgraded from investment grade status to below the triple-B credit rating threshold to become high yield bonds.

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