Rating Migrations Are Coming

March 15, 2023

Read Time 6 MIN

Nicolas Fonseca, CFA

Associate Product Manager

Forecasts for new fallen angels remain low, however the first downgrade of the year occurred in February and March has brought a flurry of rating actions.

Fallen angels underperformed broad HY by 0.26% (-1.56% vs. -1.29%) in February and now lagged by 0.32% (2.24% vs. 2.56%) YTD. Duration was once again a headwind as rates increased in February, while higher quality bonds underperformed lower quality (opposite of what occurred in January). Investors piled into short-end Treasuries (12-month yields about 5%), pulling money away from high-yield corporate funds, as the Fed raised rates by 25bps in early February (Fed Funds now at 4.50%-4.75%). Some officials signaled that more than the initially expected rate hikes were coming, with the terminal rate closer to 6.00%, and that rates may remain higher for longer as inflation appears to be stickier than originally anticipated causing duration-sensitive asset classes to be down significantly over the past month.

Total Return and Duration of Fixed Income Asset Classes

Source: ICE Data Services and VanEck. Past performance is no guarantee of future results. Not intended as a recommendation to buy or sell any securities referenced herein. 3M TBills: ICE BofA US 3-Month Treasury Bill Index. CCC & Lower Bonds: ICE BofA CCC & Lower US High Yield. Index: subset of the ICE BofA US High Yield Index and includes securities rated CCC or lower. Single-B Bonds: ICE BofA Single-B US High Yield Index: subset of the ICE BofA US High Yield Index and includes securities rated single B. Broad HY: ICE BofA US High Yield Index: comprised of below-investment grade corporate bonds (based on an average of various rating agencies) denominated in U.S. dollars. Fallen Angels: ICE US Fallen Angel High Yield 10% Constrained Index: subset of the ICE BofA US High Yield Index and includes securities that were rated investment grade at time of issuance. BB Bonds: ICE BofA BB US High Yield Index: subset of the ICE BofA US High Yield Index and includes securities rated BB. 10Y Treasury: ICE BofA Current 10-Year US Treasury Index. 30Y Treasury: ICE BofA Current 30-Year US Treasury Index.

As of February month end, rating migration forecasts continue to favor rising stars over new fallen angels. Sell-side projections generally range from $60-150bn for rising stars and approximately $30-60bn for new fallen angels. According to J.P. Morgan:

There are over $1 trillion on bonds rated BBB- by at least one agency, of which $170 billion is on negative watch or outlook.
Despite those large figures, realistically there are only ~$2 billion of issuers being downgrade to HY based. Overall, 2 issuers (GXO Logistics and Open Text) might be on the cusp of being downgraded as only one agency will need to downgrade the for its rating to drop to high yield.
There are +$300 billion of bonds rated BB+ by at least one of the three major rating agencies, of which ~$50 billion could be upgraded to investment grade as a result of at least one agency upgrade.
In our fallen angel index, there is about $20 billion which could be upgraded if one of three agencies upgrade its rating: Western Midstream, FirstEnergy, Apache, Mattel and EnLink Midstream. The two issuers that are mostly watched (Ford and Occidental Petroleum) are rated high yield by all three agencies, and there is potential for them to be upgraded sometime this year.

Over the first week of March, we’ve seen multiple actions from the rating agencies.

In the Auto space, Nissan was downgraded to HY on 3/7 by S&P. If it enters the fallen angel index at month end, auto exposure will increase significantly. Nissan was not in most sell side forecasts for potential downgrades.
In the Energy space, Western Midstream and Occidental Petroleum were upgraded to IG by Moody’s on 3/10. These two issuers were part of the April 2020 wave of downgrades, and have reduced their debt loads since then. If both exit the index, we expect Energy exposure will decline significantly

In the Banking sector, following the collapse of Silicon Valley Bank several regional banks have had their ratings placed under review for possible downgrade.

Fallen Angels Overall Stats: Fallen angels bond spreads tightened this past month by 12bps while broad high yield spreads tightened by 8bps as yields rose by the most since September of last year. Fallen angels yields increased by 40bps and broad high yield by 47bps, in line with the 10Y Treasury which is now hovering 4.00%. Duration shortened for both strategies but was a main detractor for fallen angels, alongside its allocation to higher quality bonds. With fallen angel yields back above 7%, just above its long term average, absolute yield levels continue to offer a potentially attractive entry point in spite of relatively tight spreads, and can provide a return cushion if we see spreads widen.

	Fallen Angel			Broad HY
	12/31/2022	1/31/2023	2/28/2023	12/31/2022	1/31/2023	2/28/2023
Yield to Worst	7.49	6.87	7.27	8.89	8.17	8.64
Effective Duration	5.45	5.61	5.43	4.04	3.94	3.92
Full Market Value ($mn)	112,854	114,139	112,561	1,199,909	1,246,367	1,232,134
OAS	337	307	295	481	430	422
No. of Issues	212	210	209	1,927	1,930	1,931

Source: ICE Data Services and VanEck. Past performance is no guarantee of future results. Fallen Angels: ICE US Fallen Angel High Yield 10% Constrained Index. Broad HY: ICE BofA US High Yield Index. OAS refers to “option-adjusted spread.” Please see definition for this and other terms referenced herein in the disclosures and definitions portion of this blog.

New Fallen Angels: The first fallen angel of the year came into the index with a 1.39% weight. Entegris was downgraded by S&P from BB+ to BB, with the average rating dropping from IG to HY, due to the weakening macro environment, slowness in the semiconductor industry and company-specific headwinds. Over the last 6 months, Entegris price return -1.13%.

Month-end Addition	Name	Rating	Sector	Industry	% Mkt Value	Price
February	Entegris Escrow Corp.	BB1	Technology & Electronics	Electronics	1.39	90.92

Source: ICE Data Services and VanEck. Past performance is no guarantee of future results. Not a recommendation to buy or sell any of the names/securities mentioned herein.

Rising Stars: There were two issuers upgraded from HY to IG, aka rising stars. Autopistas Metropolitanas de Puerto Rico was downgraded back in mid-2014 and upgraded by Moody’s from Ba2 to Ba1 and by S&P from BBB- to BBB, with the average rating upgrading it to investment grade. Nokia was also upgraded by S&P from BB+ to BBB- as it had a strong performance in 2022 across all segments, regaining market share and having successful cost efficiencies. Over the last 12 months, Autopistas Metropolitanas de Puerto Rico posted +5.03% price return while Nokia saw a negative 18.41% price return.

Month-end Exit	Name	Rating	Sector	Industry	% Mkt Value	Price
February	Autopistas Metropolitanas de Puerto Rico LLC	BB1	Transportation	Transport Infrastructure/Services	0.35	100.49
February	Nokia Corp	BB1	Technology & Electronics	Tech Hardware & Equipment	0.47	97.50

Source: ICE Data Services and VanEck. Past performance is no guarantee of future results. Not a recommendation to buy or sell any of the names/securities mentioned herein.

Fallen Angels Performance by Sector: The sector composition didn’t have any major changes, however, the Tech sector saw a net increase of 0.84% as there was a fallen angel and rising star this past month. Only three sectors posted positive returns, with Real Estate being the top performance of the index as spreads significantly tightened over this past month (106bps). The index price is back below $90m, still below its long term average of ~$95, with the Banking sector being the only one above par.

	Wgt (%)			OAS			Price			Total Return (%)
	12/31/2021	1/31/2023	2/28/2023	12/31/2021	1/31/2023	2/28/2023	12/31/2021	1/31/2023	2/28/2023	1M
Automotive	10.00	10.00	10.00	262	225	227	91.35	94.30	91.85	-2.16
Banking	3.81	3.87	3.93	302	242	230	96.85	100.25	100.09	0.33
Basic Industry	1.36	1.38	1.36	226	215	225	92.17	94.36	92.11	-1.97
Capital Goods	5.12	5.12	5.14	279	269	243	95.01	97.20	95.93	-0.84
Consumer Goods	3.07	3.11	3.11	275	275	249	88.90	91.20	89.49	-1.40
Energy	27.93	28.35	27.83	293	278	278	88.13	91.14	88.38	-2.53
Financial Services	0.65	0.66	0.66	540	480	465	77.20	82.17	80.33	-1.71
Healthcare	3.02	3.05	3.06	362	335	317	83.56	85.38	84.22	-0.88
Insurance	0.85	0.85	0.85	347	349	334	92.10	94.15	92.47	-1.25
Leisure	7.88	8.01	7.99	325	251	240	89.95	93.46	92.36	-0.70
Real Estate	5.13	5.28	5.43	697	576	470	79.46	83.10	84.67	2.28
Retail	5.67	5.75	5.78	471	429	406	73.75	76.65	75.96	-0.41
Services	0.38	0.37	0.36	388	380	441	87.11	89.27	84.42	-4.95
Technology & Electronics	4.20	4.33	5.17	327	276	278	85.47	89.53	87.22	-2.32
Telecommunications	11.91	12.14	12.03	423	408	406	90.04	93.05	90.51	-2.04
Transportation	2.10	2.13	1.82	279	252	201	90.49	93.04	91.63	0.28
Utility	6.93	5.61	5.50	213	196	189	89.95	91.66	88.81	-2.72
Total	100	100	100	337	307	295	87.91	90.82	88.92	-1.56

Source: ICE Data Services and VanEck. Not a recommendation to buy or sell any of the names/securities mentioned herein. Fallen Angels: ICE US Fallen Angel High Yield 10% Constrained Index.

Fallen Angels Performance by Rating: Bed, Bath and Beyond missed its 2/1 payment but was able to do so on 2/28, avoiding default and posting outstanding returns of +161%.

	Wgt (%)			OAS			Price			Total Return (%)
	12/31/2022	1/31/2023	2/28/2023	12/31/2022	1/31/2023	2/28/2023	12/31/2022	1/31/2023	2/28/2023	1M
BB	87.00	86.68	86.68	284	258	254	90.02	92.91	90.59	-1.96
B	10.95	11.18	10.66	608	543	440	82.50	85.75	87.22	1.46
CCC	1.98	2.11	2.59	1,020	929	961	60.88	65.49	64.62	-3.26
CC		0.03			9,632			5.15		161.59
D	0.07		0.08	4,726		3,401	10.00		13.47
Total	100	100	100	337	307	295	87.91	90.82	88.92	-1.56

Source: ICE Data Services and VanEck. Past performance is no guarantee of future results. Fallen Angels: ICE US Fallen Angel High Yield 10% Constrained Index.

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Important Definitions and Disclosures

Data throughout was sourced from ICE Data Services and VanEck as of 2/28/2023.

Please note that VanEck may offer investments products that invest in the asset class(es) or industries included in this blog.

This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities/financial instruments mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. VanEck does not guarantee the accuracy of third party data. The information herein represents the opinion of the author(s), but not necessarily those of VanEck or its employees.

3M TBills is represented by the ICE BofA US 3-Month Treasury Bill Index which seeks to track a subset of a single issue purchased at the beginning of the month and held for a full month. At the end of the month that issue is sold and rolled into a newly selected issue. The issue selected at each month end rebalancing is the outstanding Treasury Bill that matures closest to, but not beyond, three months from the rebalancing date.

CCC & Lower Bonds is represented by the ICE BofA CCC & Lower US High Yield Index: subset of the ICE BofA US High Yield Index and includes securities rated CCC or lower.

Single-B Bond is represented by the ICE BofA Single-B.

US High Yield Index is represented by the subset of the ICE BofA US High Yield Index and includes securities rated single B.

Broad HY is represented by the ICE BofA US High Yield Index: comprised of below-investment grade corporate bonds (based on an average of various rating agencies) denominated in U.S. dollars.

Fallen Angel U.S. High Yield is represented by the ICE US Fallen Angel High Yield 10% Constrained Index (H0CF) and the Broad U.S. High Yield by ICE BofA High Yield Index (H0A0) and includes securities that were rated investment grade at time of issuance.

Single-B Bond is represented by the ICE BofA Single-B which seeks to track the effective yield of the ICE BofA US Corporate B Index, a subset of the ICE BofA US High Yield Master II Index tracking the performance of US dollar denominated below investment grade rated corporate debt publicly issued in the US domestic market.

ICE BofA Current 10-Year US Treasury Index is a one-security index comprised of the most recently issued 10-year US Treasury note.

ICE BofA Current 30-Year US Treasury Index is a one-security index comprised of the most recently issued 30-year US Treasury note.

Yield-to-Worst (YTW): This is the lowest yield that can be received on a bond that fully operates within the terms of its contract without defaulting.

Option-Adjusted Spread (OAS): The measurement of the spread of a fixed-income security and the risk-free rate which is then adjusted for an embedded option.

A fallen angel bond is a bond that was initially given an investment-grade rating but has since been reduced to junk bond status.

High yield bonds may be subject to greater risk of loss of income and principal and are likely to be more sensitive to adverse economic changes than higher rated securities.

A rising star is a high yield bond that is upgraded to investment grade.

Duration is an estimate of how much the value of a bond portfolio would be affected by a change in prevailing interest rates. The longer a portfolio’s duration, the more sensitive it is to changes in interest rates.

There are inherent risks with fixed income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer duration fixed-income securities and during periods when prevailing interest rates are low or negative.

Index returns are not Fund returns and do not reflect any management fees or brokerage expenses. Certain indices may take into account withholding taxes. Investors cannot invest directly in the Index.

ICE BofA US High Yield Index (H0A0, “Broad HY Index”), formerly known as BofA Merrill Lynch US High Yield Index prior to 10/23/2017, is comprised of below-investment grade corporate bonds (based on an average of various rating agencies) denominated in U.S. dollars.

ICE US Fallen Angel High Yield 10% Constrained Index (H0CF, “Fallen Angels Index”) is a subset of the ICE BofA US High Yield Index and includes securities that were rated investment grade at time of issuance.

Fallen Angel U.S. High Yield index data on and prior to February 28, 2020 reflects that of the ICE BofA US Fallen Angel High Yield Index (H0FA). From February 28, 2020 forward, the Fallen Angel U.S. High Yield index data reflects that of the Fund's underlying index, the ICE US Fallen Angel High Yield 10% Constrained Index (H0CF). Fallen Angel U.S. High Yield index data history which includes periods prior to February 28, 2020 links H0FA and H0CF and is not intended for third party use.

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