Fidelity White Paper - Downgrade risks when zombies become fallen angels
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April 2020
Fidelity
White Paper
Downgrade risks when zombies
become fallen angels
Martin Dropkin
Global Head of Research, Fixed Income
George Watson
Investment Writer
This is for investment professionals only and should not be relied upon by private investors
High yield braces for fallen angels companies that could use them more efficiently. With a
recession now upon us, many zombies are at risk of being
The twin shocks to the global economy of the Covid-19 downgraded into high yield and becoming fallen angels.
outbreak and the sharp oil price decline have resonated This has significant implications for a global high yield
through all asset classes. The high yield bond market must market already reeling from the abrupt economic downturn.
now contend with a third potential shock - an influx of
downgraded investment grade bonds.
Fallen angels are attractive to high
yield investors
With a recession now upon us, Usually fallen angels find ready buyers in the high yield
market. Most fallen angels are asset rich companies
many zombies are at risk of being
with some ability to generate financial flexibility. Passive
downgraded into high yield and investors will be compelled to buy them. For active
becoming fallen angels. investors, fallen angels represent credits that often have
better access to capital than smaller, more levered
companies - a highly desirable attribute in this crisis to
help avert liquidity stresses later in the year. Trading
Last year, we released a paper about the rise of ‘zombie’
liquidity is also much better in the bonds of fallen angels
companies since the financial crisis - firms that show
than in those of smaller high yield issuers.
little signs of life but manage to survive thanks to cheap
borrowing costs. At the time, many zombies were rated as Historically, fallen angels tend to outperform when they
investment grade quality, although most were positioned move to the high yield index, with the precise moment of the
on the lowest rung in this category (BBB). second rating agency downgrade being the perfect time to
buy. However, there is reason to be cautious today, given the
In The next recession: Zombie killer1, we argued that a
amount of bonds at risk of a downgrade to high yield.
recession would be a necessary catalyst to shake some
zombies out of the system and free up resources for
Link: https://www.fidelityinternational.com/article/the-next-recession-zombie-killer-d5d5ef-en5/
1
Chart 1: The amount of US BBBs has ballooned since the financial crisis
8tn
Face value (USD trillion)
6tn
4tn
2tn
0tn
2005 2010 2015 2020
AAA AA A BBB
Index: C0A0. Source: Bloomberg, Fidelity International, April 2020.
2 Fidelity White Paper: Downgrade risks when zombies become fallen angels Fidelity InternationalChart 3: US BBs underperform BBBs to price in
The size of outstanding bonds at
arrival of fallen angels
risk of downgrade is significant
The sheer size of the face value of bonds issued by firms
2000
at risk of becoming fallen angels that will need to find
a home in the high yield market is a concern. Roughly 1500
$215 billion of US debt and €100 billion of European 1000
Basis points
debt is expected to be downgraded to high yield this
500
year.2 The face value of bonds rated BBB has grown
steadily since the financial crisis and faster than the 0
high yield market. In the US, the amount of BBB3-rated -500
bonds outstanding now equals around 70 per cent of
-1000
the entire US high yield market. 2008 2012 2016 2020
US BBB US BB Difference
Chart 2: The sheer size of potential fallen angels
could overwhelm the US high yield market Option-adjusted spread of C0A4 and H0A1. Source: Bloomberg, Fidelity International, April 2020.
2.4 80% To explain further, the possibility of a large amount of
Proportion of BBB3 to HY
debt moving into high yield could cause a crowding
Face value ($ trillion)
1.8 60% out effect for the lower rated (B/CCC) companies in the
high yield index. Fallen angels, which will largely move
1.2 40% from BBB to BB, will swell the size of the BB category
in the index, forcing managers of both passive and
0.6 20% active strategies to reallocate from riskier categories
to maintain benchmark constraints. Fallen angels will
0 0% also have stronger balance sheets than lower-rated
2005 2010 2015 2020 companies, meaning they will find it easier to issue new
HY BBB3 Proportion (RHS) bonds, exacerbating this shift.
IIndices: H0A1, C0A4. Source: Bloomberg, Fidelity International, April 2020.
Chart 4: Lower-rated European high yield firms at
In the last month, the difference between the spreads
risk of being crowded out
of BBB and BB-rated bonds in the US corporate indices
has risen to 273 basis points. While this is not yet at the 250
extremes of the financial crisis, it is at a similar level to
Face value (EUR million)
previous economic slowdowns. This partially reflects the 200
overall performance of respective benchmarks, but we
150
believe the BB spreads are also anticipating an influx of
fallen angels into the HY index. 100
50
0
2005 2010 2015 2020
BB B CCC
Index: HEC0. Source: Bloomberg, Fidelity International, April 2020.
2
JP Morgan Credit Research, 23 March 2020.
3 Fidelity White Paper: Downgrade risks when zombies become fallen angels Fidelity InternationalBBB spreads indicate some Covenant analysis, looking for loopholes that could
be exploited by issuers, is especially important in a
complacency downgrade cycle. Investment grade bonds are typically
Many of the potential fallen angels’ bonds already trade issued with no covenants, meaning they are susceptible
at spreads comparable to BB-rated bonds in anticipation to being ‘layered’ - when a company issues debt with
of a future ratings moves, so some of the impact of higher seniority, reducing the value of existing bonds - as a
downgrades is already priced in. However, our analysis company moves from investment grade to high yield.
reveals that only around 5 per cent of the US investment
grade index is currently trading at spreads equal to or
wider than comparable BB-rated bonds. Considering
around 27 per cent of the index is rated as BBB2 or BBB3 A good way to navigate the
- the categories most at risk of a downgrade to high heightened downgrade risk is to
yield - this looks a little complacent considering the near- run detailed liquidity and covenant
instantaneous stop to economic activity in some sectors.
analysis on weaker companies to
Chart 5: Given the potential for downgrades, we determine how long they can survive
would expect more US investment grade to be without additional funding.
trading at high yield spreads
25%
20% A further worry for bond investors is the threat of leveraged
% Market weight
buyouts. Private equity firms are sitting on significant
15% amounts of capital that they are likely to deploy now that
10% valuations are more attractive. Existing bondholders almost
always lose out in leveraged buyouts as the business
5% model necessitates loading up target firms with freshly
issued debt.
0%
2005 2010 2015 2020 Despite these risks, we believe investment grade bonds
US investment grade bonds trading at BB spreads are currently trading at very attractive levels, with
US bonds especially well positioned. Within the BBB
Chart shows market weight of US investment grade bonds (C0A0 index) trading wider than Fidelity’s
BB quant curves. Source: Fidelity International, Bloomberg, April 2020.
category, however, thorough research is needed to
understand those issuers most at risk from being moved
Navigating fallen angel risk into high yield. At the higher quality end of the high yield
spectrum, spreads have reached attractive levels among
As we move through this crisis, more zombies will be certain European names, but not so much in the US. A
flushed out and market stresses will begin to dissipate. In high degree of caution is also necessary at the riskier
the meantime, a good way to navigate the heightened end of the high yield spectrum (CCC/B). Credit selection
downgrade risk is to run detailed liquidity and covenant here is paramount to identify those companies that, at
analysis on weaker companies to determine how long a minimum, do not need to tap the market for further
they can survive without additional funding while access to funding in the next six months.
liquidity remains limited.
4 Fidelity White Paper: Downgrade risks when zombies become fallen angels Fidelity InternationalSectors most at risk of downgrades
Below we outline which sectors are most at risk of but not next year. And more companies have debt due
downgrades, with the caveat that government support next year that could run into the same problems unless
and economic conditions will vary depending on market dynamics improve in the interim.
which stage of the crisis each country is at. In Asia,
Additionally, credit ratings agency S&P has assumed an oil
for example, fewer investment grade bonds currently
price of around $45 next year in its models to asses energy
appear to be at risk of a downgrade than elsewhere,
companies credit rating. Oil futures strips are currently
but that could change if conditions worsen. Some
pricing oil at around $35 next year, and this mismatch could
companies will also be affected by any changes to
lead to further downgrades if the oil price does not rise to
sovereign ratings, for example, state-owned corporates
meet rating agencies’ assumptions.
and banks in countries such as Indonesia and India.
Energy Autos
The energy sector is most at risk of downgrades, being at The autos sector headed into the coronavirus outbreak
the epicentre of both the oil glut and the demand shock in a weak position, due to a softening cyclical backdrop,
from Covid-19. Around $60 billion of investment grade debt trade tensions and margin pressures caused by stricter
at the upstream end of the energy market has already environmental regulations and the need to invest in R&D.
been downgraded to high yield, out of around $90 billion Since the virus outbreak, ratings agencies’ base case
at immediate risk. Despite the already sizeable numbers assumptions for global light vehicle sales have been revised
involved, there is scope for more downgrades if the oil from flat to a fall of 15-20 per cent from last year. But there is
price stays low. significant uncertainty around these estimates as the extent
The big issue is liquidity. While leverage is spiking for all of the damage will depend on how long plants are shut
companies, it’s not high leverage that kills companies, it’s down and consumers must stay at home. Rating agencies
lack of liquidity. Many of the issuers already downgraded have taken slightly different approaches: S&P has assigned
have bonds maturing this year. With little free cash flow ratings according to their base case while Moody’s has put
due to the low oil price, these companies face a near-term most names on review for possible downgrade with the
liquidity strain just to roll over their existing debt. intention to resolve the outlook within 90 days.
The problem could continue into next year. Many Ford recently became the largest ever fallen angel as a
companies are well hedged against the oil price this year direct result of the current crisis. Several more issuers in
5 Fidelity White Paper: Downgrade risks when zombies become fallen angels Fidelity Internationalthe sector are at risk of crossing into high yield, and the Airports
aggregate face value of downgrades could be large if
S&P becomes more aggressive with its rating actions. Unsurprisingly, airports are struggling in the current
climate. In the past, downturns meant lower revenues but
not the total shutdown of air traffic. Airports are large
fixed cost businesses and are now generating significant
negative free cash flow. The path to the normalization of
Ford recently became the largest travel is also uncertain due to the impending steep fall in
economic growth as well as travel restrictions.
ever fallen angel as a direct result
of the current crisis. On top of the operating challenges, many airports have put
in place highly complex debt structures with high leverage.
The covenant ‘protections’ that were there for investors to
compensate for higher leverage have now rendered airport
financing structures too inflexible to deal with the current
conditions. As a result, many of these structures are in
Aircraft leasing precarious positions and the risk of downgrades to high yield
The aircraft leasing sector (excluding Chinese lessors) is is much higher than it has ever been.
at high risk of downgrades to high yield during this cycle.
While many firms have relatively strong liquidity positions Mineral and mining
to cover expected debt maturities and capex commitments
The investment grade metals and mining sector is now
this year, there are several challenges facing the sector.
considerably better placed than it was going into the
It is highly likely that all airlines will ask lessors for previous commodity down cycle of 2015-2016. Large cap
deferrals on lease payments as they struggle for liquidity diversified mining companies have reduced their absolute
while their fleets remain firmly on airport tarmacs. This net debt levels by as much as 50 per cent or more since
will impact cashflow for lessors who will have to decide then, and net leverage ratios are close to or below 1x,
which airlines to support. Airline defaults are likely to rise, having peaked in 2015 in many cases above 4x.
resulting in lessors being returned aircraft with limited, if
Levels of liquidity have been bolstered and average debt
any, re-leasing options. On top of this, lessors may have
maturities have been lengthened, reducing the need for
to take impairment charges on the value of their aircraft,
near-term funding. Hence, while the impact on earnings
which would directly impact debt-to-equity ratios.
and cashflow will be significant again, the impact on
Furthermore, lessors are wholesale funded, so must credit ratings should be less severe than in 2016. Miners
continuously refinance their maturing bonds, and it’s likely often operate in emerging market countries where
that none of the lessors will have access to unsecured exchange rates have depreciated significantly. This helps
bond markets for the foreseeable future. Lessors will those companies as revenues are in dollars and a large
therefore have no choice but to repay maturing debt from proportion of costs are in local currencies.
cash and undrawn facilities (reducing liquidity headroom)
or to tap secured funding lines which would increase
debt encumbrance and directly subordinate unsecured
Retail
bondholders. Secured debt as a percentage of tangible Retail in the time of coronavirus is a tale of two groups.
assets is a key metric that ratings agencies use, further Food and essential retailers will do just fine. Demand
increasing the risk of downgrades. has spiked from stockpiling and the switch to ‘at home’
6 Fidelity White Paper: Downgrade risks when zombies become fallen angels Fidelity Internationalpreparation and consumption patterns. Food retailers will food distributors. Beverage companies, particularly
be among the clear winners and there is no downgrade those with large emerging markets exposure, are likely
pressure in the sector as a result of the virus outbreak. to face challenges even in their off-trade (retail sales)
as the economic impact of Covid-19 will hit discretionary
Discretionary retail, however, is under heavy pressure
spending. Many of the beverage companies and
from mandated closures under lockdown. Aside from
food distributors had levered up in recent years to
e-commerce, there is no revenue coming into many
fund acquisitions and they may find themselves poorly
companies during this time, and even e-commerce is liable
positioned within the investment grade ratings category
to logistics disruption due to employee health concerns.
to manage this incremental shock.
A prolonged lockdown of 1-2 quarters means discretionary
Leverage remains high among some US and European
retailers will be relying largely on existing liquidity (cash,
food companies, even though headlines indicate these
credit facilities, supplier/vendor support) and their ability
companies have benefitted from consumer hoarding.
to manage, cut or defer fixed costs. This has led to large
To be fair, some issuers have done what they said they
employee furloughs by retailers, only some of which are
would do and deleveraged prior to this downturn, and
offset by government support, rent deferrals, cancelled
some of the risk has already moved to high yield. Our
orders, refusal to accept shipments, senior management
base case is that most packaged food companies
salary cuts and dividend and share repurchase
should remain investment grade, but leverage remains
suspension.
high in the BBB segment and there is some risk.
Given the focus on basic liquidity for survival, rating
agencies have been very active in the retail sector with
Leisure and gaming
notable downgrades to high yield for several companies
already. Many other mid-low BBB retail credits are also at The investment grade downgrade risk in leisure
risk of further downgrades if lockdowns are extended. and gaming varies considerably by sector. Lodging
companies and online travel agents have generally
moved to an asset-light model meaning that they are
Beverage and food distribution
far less exposed to the current downturn than they were
Many restaurants, bars and cinemas are closing as in past cycles. Therefore, only those that were already
governments around the world enforce social distancing weakly positioned within the investment grade category
policies. Data from Open Table indicates that global should see downgrade pressure.
bookings are down 100 per cent in most geographies
In contrast, the cruise industry is asset heavy and,
tracked since mid-March. Fast food may fare slightly better,
therefore, faces far greater downgrade risk. Operating
but recent data still indicates declines.
leverage plus significant negative working capital
outflows have dramatically changed balance sheet and
liquidity positions and we believe high yield downgrades
are very likely.
Data from Open Table indicates that
The risks of rating changes at the few gaming
global bookings are down 100 per
companies with an investment grade rating are mostly
cent in most geographies tracked idiosyncratic. Generally, we view the risk as being higher
since mid-March. in the gaming REITs. For operators, only the highest
quality and most conservatively financed companies
had an investment grade rating, leaving these operators
better positioned to manage through industry turbulence
This demand shock doesn’t just hurt restaurants, but also than most of their peers.
their suppliers, including many beverage companies and
7 Fidelity White Paper: Downgrade risks when zombies become fallen angels Fidelity InternationalImportant Information This document is for Investment Professionals only and should not be relied on by private investors. This document is provided for information purposes only and is intended only for the person or entity to which it is sent. It must not be reproduced or circulated to any other party without prior permission of Fidelity. This document does not constitute a distribution, an offer or solicitation to engage the investment management services of Fidelity, or an offer to buy or sell or the solicitation of any offer to buy or sell any securities in any jurisdiction or country where such distribution or offer is not authorised or would be contrary to local laws or regulations. Fidelity makes no representations that the contents are appropriate for use in all locations or that the transactions or services discussed are available or appropriate for sale or use in all jurisdictions or countries or by all investors or counterparties. This communication is not directed at, and must not be acted on by persons inside the United States and is otherwise only directed at persons residing in jurisdictions where the relevant funds are authorised for distribution or where no such authorisation is required. Fidelity is not authorised to manage or distribute investment funds or products in, or to provide investment management or advisory services to persons resident in, mainland China. All persons and entities accessing the information do so on their own initiative and are responsible for compliance with applicable local laws and regulations and should consult their professional advisers. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of illustration only. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. The research and analysis used in this documentation is gathered by Fidelity for its use as an investment manager and may have already been acted upon for its own purposes. This material was created by Fidelity International. Past performance is not a reliable indicator of future results. This document may contain materials from third-parties which are supplied by companies that are not affiliated with any Fidelity entity (Third-Party Content). Fidelity has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. Fidelity International refers to the group of companies which form the global investment management organization that provides products and services in designated jurisdictions outside of North America Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. Fidelity only offers information on products and services and does not provide investment advice based on individual circumstances. Issued in Europe: Issued by FIL Investments International (FCA registered number 122170) a firm authorised and regulated by the Financial Conduct Authority, FIL (Luxembourg) S.A., authorised and supervised by the CSSF (Commission de Surveillance du Secteur Financier) and FIL Investment Switzerland AG, authorised and supervised by the Swiss Financial Market Supervisory Authority FINMA. For German wholesale clients issued by FIL Investment Services GmbH, Kastanienhöhe 1, 61476 Kronberg im Taunus. For German institutional clients issued by FIL Investments International – Niederlassung Frankfurt on behalf of FIL Pension Management, Oakhill House, 130 Tonbridge Road, Hildenborough, Tonbridge, Kent TN11 9DZ. In Hong Kong, this document is issued by FIL Investment Management (Hong Kong) Limited and it has not been reviewed by the Securities and Future Commission. FIL Investment Management (Singapore) Limited (Co. Reg. No: 199006300E) is the legal representative of Fidelity International in Singapore. FIL Asset Management (Korea) Limited is the legal representative of Fidelity International in Korea. In Taiwan, Independently operated by FIL Securities (Taiwan ) Limited, 11F, 68 Zhongxiao East Road., Section 5, Xinyi Dist., Taipei City, Taiwan 11065, R.O.C Customer Service Number: 0800-00-9911#2 Issued in Australia by Fidelity Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”). This material has not been prepared specifically for Australian investors and may contain information which is not prepared in accordance with Australian law. ED20-101
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