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Fridson – Fallen-Angel Watch: How Will Triple-B Downgrades Affect the High-Yield Market?

Synopsis: Based on our analysis of past surges in fallen-angel supply, we expect that the future spread-widening directly attributable to large-scale downgrading of present BBB bonds, if it occurs, will be in the range of 50–60 bps.

There is a specter haunting the high-yield market…the specter of BBB downgrades.

Over the past five years, the face value of the ICE BofAML US Corporate BBB Index increased by 65%. By contrast, the spend-like-a-sailor U.S. government debt, as measured by the ICE BofAML US Treasury Index, grew by “only” 24% over the same period. Not only the quantity, but the quality of bottom-tier investment-grade bonds has raised concerns, including the possibility of a spillover to high-yield that might create a supply problem:

More broadly, the question is how high the Fed can raise rates before companies struggle to service their cost of debt and whether companies in the triple B segment will be downgraded to junk after piling on leverage in deals. When that happens, higher-quality and less-leveraged companies will probably benefit—but at that point, equity markets and other risky securities might start to struggle as well, which would hurt investors’ ability to earn returns (see note 1). (Boldfacing added.)

To keep this problem in perspective, large-scale downgrading of BBBs will almost certainly improve the high-yield universe’s ratings mix. Most issues will probably fall from the BBB to the BB tier. Few if any will go directly from BBB to the below-speculative-grade-median CCC tier.

More to the point, though, would not the dumping of tens of billions of dollars of IG bonds into the HY universe depress HY prices, based on simple principles of supply and demand? In reality, there is nothing simple about supply and demand when it comes to the high-yield market. For example, the financial press sounds alarms from time to time about the buildup of the high-yield calendar, warning that the new supply will crush prices of outstanding issues. The actual state of affairs at such junctures is that CFOs of high-yield companies that will need to finance at some point are collectively responding to a price signal that speculative-grade spreads are inordinately narrow, making it extremely attractive to issue. Seeing the forward calendar build up, portfolio managers stop chasing after secondary paper trading at ridiculous levels. Spreads consequently widen to a more realistic risk-reward tradeoff and many deals quietly disappear from the calendar. After all, they merely represented opportunistic financing plans by companies with well-managed maturity schedules and no urgent need to come to market. The frequently ballyhooed crushing of prices by new-issue supply has never happened, except under highly unusual conditions in the late 1980s (see note 2).

In contrast to new issuance activity that is sensitive to market conditions, fallen angels enter the high-yield universe whether or not investors are receptive to incremental supply. Even in this case, however, the impact is not as simple as, “more supply, same amount of dollars invested, prices fall proportionately.” For one thing, the investment rules under which IG portfolio managers generally operate are not as inflexible as media accounts sometimes suggest. That is, they are not typically forced to sell a bond the instant it falls below Baa3/BBB–. Institutional investors recognize that enforcing such a rule would be counterproductive, as it would mandate fire sales. Furthermore, a great deal of paper that falls to speculative-grade stays in the general accounts of life insurance companies, which are not required to sell unless the obligations become impaired or they bump up against regulatory limits based on the overall ratings mix of their portfolios. Non-mandatory selling of fallen angels reduces a life insurer’s regulatory surplus, in turn restricting its ability to generate additional premium income by writing new policies.

Owing to such nuances, investors should carefully scrutinize any attempt by analysts to quantify the expected impact of future downgrading of BBB bonds. A good principle to follow is to put limited faith in the power of predictions absent a persuasive explanation of the past. The key challenge in measuring the impact of past fallen-angel-driven supply surges is the presence of confounding factors. That is to say, many other events are causing spreads to move at the same time that investment-grade bonds are dropping to speculative-grade in large numbers. Sorting out the influences of all those events is no simple task.

Methodology
To isolate the impact of a substantial increase in fallen-angel supply, we employ the FridsonVision Fair Value Model (see note 3)—with an important modification—to estimate what the ICE BofAML US High Yield Index’s option-adjusted spread (OAS) should have been prior to and following the supply surge. The fair value model’s explanatory variables are the factors that explain variance in the OAS over time. If the spread is at fair value prior to the surge and wider than fair value following the surge, and if nothing else out of the ordinary has occurred in the interim, then in principle the disparity between fair value and the post-surge actual spread represents the impact of the surge. As we shall see, the facts on the ground are somewhat messier.

The modification that we make in our model is to add the Chicago Board Options Exchange S&P500 Volatility Index, or VIX, as an explanatory variable. This change increases the model’s percentage-of-variance-explained (R2) from 80% to 91%. The question naturally arises, why do we not include VIX in our standard model? That is because we regard VIX, popularly known as the “fear gauge,” as the non-fundamental, i.e., emotional component of high-yield pricing. It is precisely when the spread is inflated because of emotional factors, rather than true credit ones, that value-oriented investors should step up their high-yield allocations. A very high R2 produced by inclusion of VIX will tend to suppress such BUY signals. For the present exercise, however, we want to include among our explanatory variables all factors other than supply, at least to the extent feasible. Ideally, this method will leave the supply surge as the sole explanation of any observed gap between actual OAS and fair value.

Case Study #1—2016 energy price plunge
We begin our analysis with a recent case of a surge in high-yield supply driven by fallen angels. Between Dec. 31, 2015 and Feb. 29, 2016 the face value of the ICE BofAML US Fallen Angel High Yield Index rose by $34.4 billion, an increase of 21.2%. That represented the eighth largest two-month increase out of 255 months of the fallen-angel index’s available history, excluding two observations that were affected by the index operator’s June 2002 initial inclusion of Rule 144a issues in its high-yield indexes. We selected a two-month interval because in this case, the non-fallen-angel component of the ICE BofAML US High Yield Index (the ICE BofAML US Original Issue High Yield Index) barely budged over the period (–0.3% change in face value). Consequently, the $34.4 billion increase in the fallen-angels component accounted for more than 100% of the $30.5 billion increase in the overall high-yield index’s rise in face value. Selecting this period, therefore, eliminates the possible confounding factor of increased supply that was unrelated to downgrading of investment-grade debt to speculative-grade debt, the phenomenon for which we seek to quantify the impact.

The $34.4 billion growth of the fallen angels’ face amount during 2016’s first two months was driven primarily by downgrades of Energy issues. Over that span the face amount of the ICE BAML Fallen Angel Index’s Energy segment increased by $22.0 billion. The large migration of investment-grade Energy issues coincided with a low point in oil prices. The Generic US Crude Oil, West Texas Intermediate contract, which had been declining steadily from a high of $107.26/barrel on June 20, 2014, bottomed out at $26.21 on Feb. 11, 2016.

According to our Fair Value Model, enhanced by VIX, the predicted OAS for the ICE BAML High Yield Index on Feb. 29, 2016 was 699 bps. The actual OAS on that date was 775 bps. On the face of it, the surge of fallen-angel supply caused the high-yield spread to be 76 bps wider than it should have been. That amount compares with a standard deviation of 83 bps for the Fair Value with VIX Model, implying that the impact of the new fallen-angel supply was not inconsequential.

There is a possible flaw in this interpretation, however. To begin with, the Fair Value with VIX Model indicates that at the beginning of our two-month analytical window, prior to the fallen-angel surge, the ICE BofAML High Yield Index was 67 bps wider than fair value (695 bps actual spread minus 628 bps predicted). If the same factors not captured by the model were influencing spreads in both periods, then one could argue that the supply surge caused the high-yield spread to widen by a negligible nine basis points (76 bps minus 67 bps).

One obvious candidate for a factor not captured by the model is the widening of spreads on Energy bonds themselves as a function of the further drop in crude-oil prices during this case study’s observation period. Pursuing that thought, we find that on Dec. 31, 2015 the Energy component accounted for 10.92% of the ICE BAML High Yield Index’s market value and was already quoted at a distressed weighted average OAS of 1,415 bps. Two months later, the comparable figures were 11.06% and 1,609 bps. Based on those figures and the ICE BAML High Yield Index’s spreads of 695 and 775 bps on the two dates, representing a widening of 80 bps over the period, we calculate that the non-Energy component widened by 64 bps (from 607 bps to 671 bps) over the period.

This means that widening of the Energy component, a calculation affected by the addition of the fallen angels between the two dates, accounted for just 20% (16 bps out of 80 bps) of the spread-widening on the ICE BAML High Yield Index. Other factors not captured by our model, whatever they may have been, had a bigger impact. The interpretation most generous to analysts who warn of a major jolt from BBB downgrades is that the sole non-model-captured factor in place on Feb. 29, 2016, other than the impact of the spread-widening on Energy issues, was the separate (albeit also driven largely by the Energy industry’s woes) effect of the increase in fallen-angel supply. In short, we can regard 76 bps – 16 bps = 60 bps as the upper bound of OAS impact on the high-yield spread in the early 2016 oil price plunge. The lower bound is nine basis points, calculated above.

Case Study #2—2005 General Motors downgrade 
Our second case study involves the largest two-month percentage increase in face value of the ICE BAML Fallen Angel Index since its Dec. 31, 1996 inception, other than the index’s previously mentioned mid-2002 first-time augmentation with Rule 144a issues. The fallen-angel index’s face value increased by $43.4 billion, or 31.21%, from March 31 to May 31, 2005. That net increase was more than fully accounted for by the entry of $45.5 billion face amount of bonds of General Motors (GM) and its captive finance subsidiary General Motors Acceptance Corporation (GMAC), both of which fell to a Composite Rating of BB1. Furthermore, the $43.4 billion of fallen-angel debt added to the ICE BAML High Yield Index during the period more than fully accounted for the $42.5 billion (a 7.11% increase) growth in that index’s face value. As in the previous case study, we can attribute any impact of supply-driven spread impact we find to downgrades from investment-grade, as opposed to new issuance.

On May 31, 2005 the Fair Value with VIX Model predicted an OAS of 274 bps for the ICE BAML High Yield Index. The actual OAS on that date was 413 bps. By subtraction, the simplest explanation is that the huge influx of fallen-angel supply caused the high-yield spread to be 139 bps wider than it otherwise would have been.

As in the previous case study, however, we find that at the base date high-yield bonds were considerably cheaper than our model predicted. On March 31, 2005 our fair value estimate was 271 bps versus an actual spread of 352 bps, a disparity of 81 bps.

If we assume that the same non-model-captured factors that caused the ICE BAML High Yield Index to be 81 bps wider on March 31, 2005 were in place two months later, we then calculate the impact of the entry of GM/GMAC fallen angels as 139 bps – 81 bps = 58 bps. Mimicking the analysis presented in our first case study, we also isolated the spread impact of the GM/GMAC bonds themselves, as distinct from their impact on supply. On March 31, 2005 the GM/GMAC bonds were not in the ICE BAML High Yield Index, so their widening from that date does not affect our calculations. On May 31, 2005 they represented 6.16% of the ICE BAML High Yield Index’s market value and had a weighted average OAS of 533 bps. Based on these numbers we calculate an OAS of 405 bps for the non-GM/GMAC component, not very different from the ICE BAML High Yield Index’s 413 on the same date. Subtracting the difference of eight basis points from the 58 bps calculated just above, we put the lower bound of the GM/GMAC downgrading impact at 50 bps. The upper bound is the raw 139 bps calculated above.

Conclusion
Predicting the impact on high-yield spreads of the large-scale downgrading of BBB bonds that some analysts expect is no simple task, given other factors that will act concurrently on spreads. To be credible, any such prediction must be based on a methodology that provides plausible estimates of past surges of fallen-angel supply. Our judgment, based on analysis of two very big surges of the past, is that the likely spread-widening that will be directly attributable to a major downgrading of BBBs—if it happens— is in the range of the lower bound of 50 bps in the 2005 GM/GMAC downgrading and the upper bound of 60 bps in the 2016 Energy downgrading. Note that the greatly feared mass downgrading of BBBs may occur in conjunction with other events that cause additional spread widening. This piece focuses solely on the spread-widening that will result directly and exclusively from a swelling of fallen-angel supply.

David Sherman, President of Cohanzick Management LLC, suggested the topic addressed in this piece. 

Marty Fridson, Chief Investment Officer of Lehmann Livian Fridson Advisors LLC, is a contributing analyst to S&P Global Market Intelligence. His weekly leveraged finance commentary appears exclusively on LCD, an offering of S&P Global Market Intelligence. Marty can be reached at [email protected]

Research assistance by Kai Zhao and Shuo Li.

ICE BofAML Index System data is used by permission. Copyright © 2018 ICE Data Services. The use of the above in no way implies that ICE Data Services or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of Lehmann, Livian, Fridson Advisors, LLC’s use of such information. The information is provided “as is” and none of ICE Data Services or any of its affiliates warrants the accuracy or completeness of the information.

Notes
1. Alexandra Scaggs, “Can US triple C-rated bonds stay ahead of the pack? High-yield debt is looking vulnerable after strong outperformance in the first half.” Financial Times (July 4, 2018).

2. In the late 1980s, dominant underwriter Drexel Burnham Lambert’s rivals “improved” upon that firm’s innovation, the highly confident letter. This was a device that enabled bidders in takeover battles to represent that the financing for their bids was effectively assured. Drexel’s competitors provided bridge loans, booked on their own balance sheets, to the bidders they backed. These bridge loans were often made to overleveraged and deteriorating credits, creating an urgency for them to be replaced by permanent financing, i.e., bonds. The investment banks that saddled themselves with the “burning bridges” therefore faced extreme pressure to float high-yield bonds, regardless of prevailing market conditions. The market-wrecking consequences of desperation-driven offering was compounded by the fact that investors were smart enough to shun the obvious Chapter 11 candidates. Some major investment banks were nearly bankrupted by these imprudent transactions. The silver lining was that they learned from their near-death experiences, with the result that since that time high-yield investors have not seen spreads blow out as a consequence of forced offerings.

3. For details of our Fair Value methodology see “Fair Value update and methodology review” (LCD News, Jan. 24, 2018). In our model, the factors that explain variance in the high-yield spread over time are credit availability, selected economic indicators, the current default rate (a minor factor), Treasury yields, and a dummy variable representing the era of quantitative easing by the Fed.

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