Virus Sell-Off Turns Bonds Into ‘Fallen Angels.’ Here’s Why Downgrades Matter

(Bloomberg) -- Being a fallen angel is not a good thing, whether in the Bible or the bond market. For investors, a fallen angel is a company that has been downgraded and lost its investment-grade debt ratings -- a fall that can have costly consequences. Downgrades of just that kind have been pouring down on the bond market like cold March rain since pandemic-driven lockdowns triggered a global sell-off. The downgrades turned more than $92 billion of bonds into fallen angels in March alone, with more threatening to follows. But for some of those companies, the blow may be cushioned by an unprecedented move by the U.S. Federal Reserve.

1. How many bonds have been downgraded?

Companies are facing a near unprecedented rate of downgrades as the coronavirus pandemic, paired with the worst oil rout in decades, threatens their supply chains, consumer demand or both. More than $92 billion of debt fell to high yield from investment grade in March between 11 different companies, according to research firm CreditSights. Most credit strategists see twice as much damage ahead, or more. Here are their forecasts that include the remainder of the year:

2. What are fallen angels?

Generally speaking, a fallen angel is a bond that is downgraded to BB+ or below (categories considered junk, or, more politely, high yield) by at least two of the three major rating firms -- Moody’s Investors Service, S&P Global Ratings and Fitch Ratings -- after being formerly rated BBB- or higher (categories that are investment grade). Downgrades can happen when a company isn’t creating enough revenue or generating enough cash to service its debt, or when it takes on so much debt that its financial leverage -- usually calculated by debt as a measure of earnings -- becomes disproportionate.

3. What do the downgrades do?

A fall to junk status affects both borrowers and investors. Downgrades make borrowing more expensive, and could mean that lenders will tack on protections in the form of debt covenants. Junk status can force a wave of selling by investors whose mandates prevent them from holding credits below investment grade. The prices of downgraded bonds may also need to fall to compensate investors for holding what’s become a less liquid, or actively-traded security. On the other hand, traders often start selling off troubled bonds well before the rating agencies weigh in, which can limit the amount of forced selling once a downgrade actually occurs. That’s why investors often say credit ratings are retroactive and backward-looking.

4. What is the Fed doing?

As part of a massive response to the sharp drop in economic activity, the Fed announced that it will buy corporate bonds -- including, for the first time ever, some that are below investment grade. That only applies, however, to debt of companies that were investment-grade rated as of March 22, and subsequently downgraded to no lower than BB-, or three levels into high-yield. That is, fallen angels who only recently lost their wings and haven’t fallen very far.

5. Who will that help?

Ford Motor Co. and Macy’s Inc. both stand to benefit given the timing of their downgrades. The automaker’s bonds rallied more than 10 cents after the Fed action was announced, according to Trace pricing data. Occidental Petroleum Corp. looks set to miss out under current provisions. The company, which has $35 billion of index-eligible debt outstanding, fell into junk territory on March 20 with a cut to BB+ by Fitch Ratings following an earlier action by Moody’s Investors Service.

6. Are the downgrades justified?

It depends on who you ask. Credit Roundtable, an industry group for corporate bond investors, says that credit raters have mostly acted rationally and sensibly through the current crisis, according to the group’s vice chairman David Knutson. There had been concern that raters may not have been sticking to their motto in “rating through the cycle,” which acknowledges near-term shocks but tries to maintain a longer-term view of the borrower’s underlying health, particularly for large, well-capitalized companies. Critics of the agencies point to the way companies in recent years had loaded up on cheap debt to fuel acquisitions, often sacrificing credit metrics in the process. Many investors have argued that raters weren’t hard enough on those firms, cutting them too much slack when companies promised to reduce their debt load sometime in the future.

7. What’s the incentive to stay investment grade?

Market access is a big one -- investment-grade companies tend to be the largest employers in the world, and it’s important for them to be able to borrow cheaply and frequently. Higher credit ratings tend to translate into lower borrowing costs. The average U.S. investment-grade company pays a rate of about 3.5%, while high-yield is nearly 10%.

8. Where did the expression ‘fallen angel’ come from?

A 1984 story in American Banker newspaper attributed it to David Solomon, head of Solomon Asset Management, which at the time was a leading investor in the emerging field of junk bonds. (He’s not to be confused with the current head of Goldman Sachs Group Inc.)

The Reference Shelf

• The tipping point for BBBs is closer than ever amid the coronavirus and plunge in oil prices.
• A data visualization of how the BBB universe got to be so large, mainly due to mega mergers and acquisitions.
• An FTSE Russell report, “Fallen Angels in the US credit market.”
• A Bloomberg News story showing downgrades occurring at the fastest pace since the 2008 financial crisis.
• A feature on how the tipping point for BBBs is closer than ever amid the coronavirus and plunge in oil prices.

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