‘Fallen angels’ may lead to next black swan

Downgraded bonds could exacerbate a downside shock

Afew weeks ago, we noted that the high-yield market was extremely overvalued even if we adjusted for the huge share of Bb-rated bonds, which are the highest tranche in the junk bond market (in terms of ratings quality). But maybe the story is less about the current razorthin high-yield spreads, but more about the amount of credit that could get downgraded from investment grade to junk should the United States economy slow down considerably, which, in turn, could disrupt the entire high-yield market and amplify the shock of a slowdown.

Of all U.S. corporate bonds that are rated investment grade, the Bbb-rated category accounts for US$3.1 trillion, or 56 per cent of the total index. That share was less than 35 per cent at the end of 2009. This means the investment-grade market is being populated with much weaker credits. These companies are more susceptible to downgrades should the economy hit a rough patch, just like last year when a record Us$180-billionplus worth of bonds were downgraded to junk — the so-called fallen angels.

Most leading economic growth indicators have now peaked and rolled over. The current macroeconomic backdrop is that of slowing growth and is exactly the sort of environment that could see a rise in these fallen angels if we enter into a growth recession that impinges on cash-flow streams and profit margins. It is this Us$3-trillion-plus debt, or a good chunk of it, that could be teetering on the brink of being pushed into junk status. In turn, this could increase the funding costs for the companies whose bonds are downgraded.

But by how much? We looked at past experiences to see what happens to a company’s credit spread once an investment-grade bond gets downgraded to junk. Using the constituents of the ishares Fallen Angels USD Bond ETF, we were able to look at specific bonds that went from investment grade to junk last year. In the period leading up to the downgrade, their spreads with respect to Treasuries widened by an average of 107 basis points (median 77 basis points).

If company balance sheets significantly deteriorate or if their outlooks are revised to “negative,” a sudden jump in spreads could risk destabilizing the entire high-yield market, with implications for all asset classes.

For example, we found there was a significant and negative relationship between high-yield spreads and the S&P 500’s forward P/E multiple. If we were to even see a 100-basis-point increase in the current spread level from where it is today, that would drag down the multiple to 17x from the current level of 21.1x. Using the forward EPS, it would mean the value of the S&P 500 could be up to 20-per-cent below where it is today.

Clearly, a rise in fallen angels could be a black swan event with major ramifications. For the economy as a whole, a bulk of downgraded bonds increases the debt cost of capital and could exacerbate the downside shock. If this risk were to materialize, it is likely that the U.S. Federal Reserve would restart its corporate bond-buying program, which would contain the scale of the fallout.

Even after accounting for that possibility, the risks of this event are too big to ignore, and all policy-makers and investors alike should watch out. For all the focus on the “taper,” don’t think for a second that the Fed won’t be aggressive in easing policy again if this fallen angel risk becomes a reality.

A SUDDEN JUMP IN SPREADS COULD RISK DESTABILIZING THE ENTIRE HIGH-YIELD MARKET.