When angels fall...

AXA Investment Managers (AXA IM) examine the credit migration from Investment Grade to High Yield and present a method for estimating the mark to market impact of fallen angels1 based on an empirical analysis of credit indices.

Fallen angel risk is currently low2, however, if the current strength in corporate earnings starts to ebb, investor concern about fallen angels could return.

In a scenario of rating deterioration, fallen angel risk could erode 10-25% IG spreads over the next 12-18 months: AXA IM’s analysis assumes a deterioration in the rating cycle that would trigger downgrades and drive fallen angel volumes higher within IG credit; ditto for fallen angel mark-to-market risk.

Greg Venizelos, Senior Credit Strategist at AXA IM, commented:

“Fallen angel risk appears contained for now but we are witnessing a rise in idiosyncratic risk. Fallen angel volumes ticked higher in November, for example, by the most since March 2016. Moreover, the rise in BBBs credits over the past decade, makes fallen angel risk very pertinent.”

Consumer, retail and media sectors are hotspots for downgrades

The most severe fallen angel cycle took place after the dotcom bubble in the early 2000s with the telecomm and technology sectors at the epicentre. While the spread widening was not as dramatic as what was seen during the global financial crisis in 2007-2008, the rating migration into HY was severe and protracted. The next hotspots for downgrades may be the consumer, retail and media sectors where the structural migration online is putting material pressure on traditional business models.

Benchmarked funds that replicate credit indices are also at risk

AXA IM estimate that the global credit index turnover is close to 20% annually, due to many investor mandates dictating that bonds must be sold at the point of IG index exclusion. Historically, this tends to be the point where credit spreads peak and bond prices trough, resulting in the highest crystallised loss. Barclays estimates the US corporate Bonds index faces an annual leakage cost of 25 basis points due to forced selling alone. Funds that have the discretion to avoid forced selling can capture the credit carry more efficiently through the downgrade volatility. This way an investor can avoid the inherent asymmetry of credit risk, namely earning a few percentage points of carry vs losing tens of percentage points through forced selling or default.

Lionel Pernias, Head of Buy and Maintain London, at AXA IM, added:

“It is important investors look to what lies ahead. Any increase in fallen angels could create an adverse environment for index funds as it will eat into credit returns with unwanted concentration risk and no credit selection or quality control. Valuations notwithstanding, we maintain our preference for lower rated credit and more cyclical businesses at the short-end of the curve. This is due to the superior spread carry, amid rising rates while we are currently very cautious on (supposedly) defensive sub-sectors which can have problems adjusting to rapid technological changes and new consumer patterns.”

“Strategies such as buy and maintain, can be an effective way for long-term bond investors to gain exposure to the returns generated from a broad, diversified portfolio of investment grade bonds, with less market risks and in a low-cost way.”

To see the full research paper please see here.