Rising Stars Could Emerge AgainNicolas Fonseca, CFA, Associate PMJanuary 26, 2021
Credit ratings upgrades from high yield to investment grade (“rising stars”) may provide a more meaningful source of value for high yield investors this year compared to 2020, given expectations for US economic growth to accelerate this year. On average, 5.5% of fallen angels per year have historically regained investment grade status per year vs 2.8% of the broad high yield market (since 2003)1. After a dearth of rising stars in 2020 amid a wave of downgrades, rising stars could emerge again in 2021.
The higher quality tilt of fallen angels provides a good starting point: 56% of the index is only one-notch away from regaining investment grade status, while 84% are within two notches. Many companies have a strong incentive to regain investment grade status2. Many fallen angels have balance sheets that were structured to be more efficient as investment grade companies. An investment grade rating provides lower funding costs and greater financing flexibility, as well as a much larger pool of available capital (the investment grade bond market is more than 5x larger). Several companies that were downgraded during 2020 said that one of their main goals was to be back on the investment grade status. To name a few, OXY said on its Q2 2020 earnings call that their intent was to get back to an investment grade status, as well as Western Midstream when it stated that restoring their balance sheet and securing investment-grade credit ratings were priorities.
The structural distinction between the high yield and investment grade corporate bond markets results in forced selling of fallen angels, while a lag in credit ratings actions results in this forced selling occurring ahead of the actual downgrade. Historically, fallen angels experienced an average price decline of about ~6-7% in the 6 months prior to being downgraded, followed by a complete price recovery over the following 6 months. What happens to those bonds that are upgraded? The chart below shows a similar phenomenon. We looked at rising stars from 2003 until 2020 and found out that in the 12 months before an upgrade back to investment grade, fallen angels experienced an average cumulative price return of about 6.4%.3
What drives this? Similar to the lag experienced when bonds are downgraded, credit rating agencies can often lag the market on upgrades as well. The market is often able to identify companies that exhibit improving fundamentals and are able to meet financial obligations with lower levels of credit risk. While investment grade portfolio managers may be wary of filling up their non-investment grade portfolio limit with fallen angels (due to deteriorating fundamentals, headline risk, etc.) they may be much more willing to hold a potential rising star ahead of an upgrade in order to capture the higher yield and price appreciation potential.
Source: ICE Data Indices, VanEck.
1 Source: ICE Data Indices
2 Source: VanEck
3 Source: ICE Data Indices, VanEck as of 12/31/2020.
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.
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ICE BofAML 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, Index) is a subset of the ICE BofA US High Yield Index and includes securities that were rated investment grade at time of issuance.
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Authored byNicolas Fonseca, CFA