Previous slowdowns of four years ago and during the financial crisis precipitated a so-called ‘fallen angels’ cycle where BBB-rated investment-grade companies were downgraded en masse into high-yield or junk status, fuelling volatility and market instability.
BBB debt, the lowest investment grade tranche, has been growing strongly in the last few years and now makes up almost half of all the investment grade credit in Europe, and as its economy slows, a surge in downgrades – from investment grade to junk – could have a significant knock-on effect on the wider debt markets.
BBB issuance in Europe last year, at €275bn, dwarfed high-yield bond issuance at €70bn, according to Refinitiv, suggesting the impact of a fallen angels scenario could be greater. In the US, which has not seen the same squeeze on growth, the gap between BBB issuance last year, €318bn, and high yield, €106bn, was not as large (see chart 1).
“The large share of BBB bonds in Europe is a huge risk. It would be problematic if a chunk of these BBB bonds were to be downgraded to high yield.”
An unsettled market
Bank of America Merrill Lynch, for one, is worried. “We feel we need to shout about the risk of the European BBB market even louder in an environment where European economic momentum has slowed meaningfully, and where the growth risks are still firmly to the downside,” the bank warned in January.
It is not alone in its unease. Thomas Romig, Frankfurt-based head of multi-asset at Assenagon Asset Management is one of many who are concerned.
“The large share of BBB bonds in Europe is a huge risk, particularly now as the economy is slowing,” he says. “It would be problematic if a chunk of these BBB bonds were to be downgraded to high yield,” Romig says.
The high yield market has already seen signs of volatility. During the last quarter of 2018 there were sizeable outflows from high-yield bond funds, after generally having held stable during the first nine months of last year. Net redemptions from funds that invest in European high-yield bonds totalled more than €3.3bn in the fourth quarter of 2018, according to Morningstar (see chart 2).
The total return of the global high-yield market fell by 3.4% in US dollar terms during Q4, while the European high-yield market posted its largest negative quarterly performance since Q3 2011.
Speculative bonds – CCC and low-single B-rated – were especially affected following weaker-than-expected average quarterly earnings, according to Franklin Templeton.
Fund selector sentiment also seems to have turned more negative, according to Last Word Research.
The number of pan-European fund selectors looking to reduce their high-yield bond exposure outnumbered those intending to increase their positions by the second-largest margin in more than four years, according to research made in Q4 2018 (see chart 3).
The turbulence of the fourth quarter has certainly made high-yield investors nervous, admits high-yield debt manager Andrew Wilmont, who manages the Pictet EUR High Yield Fund (see chart 5).
Investor nervousness is already having an impact on issuance. European high-yield issuance volumes fell by 64% in January, compared with a year earlier. The handful of issuances included Telecom Italia and Portuguese utility EDP and French car part distributor Autodis.
Periods of economic deceleration in 2005, 2009 and 2015 were swiftly followed by a ‘fallen angels’ cycle, where weak investment grade-rated companies were downgraded to junk bond status, according to Bank of America Merrill Lynch Global Research.
If Europe’s economic cycle continues to weaken, low investment-grade, BBB-rated companies run the risk of being downgraded, sparking another ‘fallen angels’ cycle.
“Under such a scenario, you could see relatively large companies moving into the high yield market and that will cause volatility,” warns Wilmont.
The maximum allocation of a single company in most European high-yield indices is constrained to 3%, which should mitigate the impact on existing high-yield investors.
“Nonetheless, if too many companies are downgraded at once, that would be a problem,” Wilmont continues. “The bonds of the relegated company would suck money in from existing investors, increasing competition and resulting in higher yields.”
A sharp increase in the number of ‘fallen angels’ is bad news for the companies affected. However, its impact on the asset class as a whole could be mixed.
During previous ‘fallen angels’ cycles, a number of large companies, such as Dutch retailer Ahold, Italian carmaker Fiat and British Airways, have had debt issuances downgraded to junk without causing significant losses in the asset class.
If the downgrades are anticipated beforehand, the elevated risk can get priced into the spread. The Bank of America Merrill Lynch European Currency High Yield Index, for example, is already anticipating a correction and, as a result, is down by 2% during the past year (see chart 4).
Lucas Strojny, a multi-asset portfolio manager at Amilton Asset Management in Paris, says the market turbulence in late 2018 created opportunities in riskier areas of the credit market.
“We had limited exposure to credit in our portfolios over the past two years, but the levels of yield have increased a lot, providing attractive valuations,” Strojny says. “As a result, we started building high-yield positions at the end of the last quarter of 2018.”
Strojny has a clear preference for European over US high yield because of the lower level of defaults and less exposure to energy companies, which stand to lose out more from a slowing economy.
A number of US energy companies defaulted in 2015/16 following the dramatic drop in the oil price.
“Europe is still growing at moderate pace and we expect defaults to stay low as the central banks are still accommodative. Therefore, we don’t see a major liquidity risk,” Strojny adds.
The European Central Bank (ECB) also has a role to play in limiting the damage caused from a ‘fallen angel’-type scenario.
If the central bank can prevent refinancing costs from rising to unsustainable levels, downgrades will be limited as long as the eurozone economy stays out of recession.
“It’s important the ECB tightens monetary policy with care,” says Wilmont. “Recessions are often caused by central banks that are too hawkish.”
In light of the weakening economic data in Europe, Pictet’s high-yield fund, managed by Wilmont, has adopted more conservative positions. “We prefer not to own bonds of companies with the highest debt levels,” he says. “We are overweight non-cyclical sectors and underweight cyclical sectors like autos.”
Pictet’s credit group has also conducted stress tests on the potential impact of prolonged slowdown. “We calculate the effects on companies of higher sales growth or a strengthening economy to identify opportunities.
In this [weakening economic] environment, we are doing the reverse – identifying possible threats,” Wilmont says.
Notwithstanding the risks, in the yield-starved world European investors inhabit high-yield bonds remain attractive to some investors.
“As long as there’s no imminent recession risk in Europe, we will maintain our position. In the current environment we get remunerated by the coupon and the attractive carry. We will probably take an additional position in another fund in the near future,” Strojny says optimistically.
Strojny is already invested in the Nordea European High Yield Bond Fund (see chart 5) and La Française Rendement Globale, a fund with a buy-and-hold strategy that only holds bonds that will expire in 2022.
In early February, European high-yield spreads were at 478 basis points over German bunds. If spreads narrow towards 400 basis points, Stronjy says it will be a sign that he should reduce his position again.
High-yield bond manager Wilmont is not positioned for such a scenario. “I don’t expect any return from price appreciation. We focus on lower-risk credit with a lower duration instead. External factors such as a no-deal Brexit or an escalation of the trade conflict between the US and China could cause a recession.
“In such an environment you should focus on protecting your coupon. If you buy the index, you receive 4.5% in expected coupons.
Since we are positioned more defensively, we would expect 4%. That would still be a decent return in the current environment.”