The surprise drop in Federal Reserve interest rates on Tuesday did not appease equity investors about the impact of the coronavirus, but it appears to have stabilized the corporate bond trade.
Whatever the final impact of the epidemic on the U.S. economy, however, so-called fallen angels like Kraft Heinz are a big concern for the lowest-rated debt.
The average yield on US bonds classified as speculative or “undesirable” by the rating companies is now 6.3%, according to an index by ICE Bank of America Merrill Lynch. This figure was over 5.9% two weeks ago, but remains contained, especially given the violence of the initial sale on the junk bond market.
Investors were caught off guard precisely because the ultra low rates had pushed them into the riskiest paper. From December, the debt of the most financially distressed companies – rated CCC or lower – experienced a massive recovery after several months of underperformance.
Can the Fed protect this market? If the economic impact of the Covid-19 epidemic turns out to be as serious as equity investors fear, the action of the central bank will not be enough to offset the increase in default rates. And even if the economy is resilient, another danger is looming now.
Fallen angels are businesses that lose their investment rating and are downgraded to unwanted territory. Most funds are not mandated to hold lower-rated debt securities and may need to find a peer among the smallest clan of high-yield investors to buy their fallen angels. Analysts have long feared a crashing paper wave in the high-yield market as many companies were downgraded to BBB. This category, a cut above the junk, now represents around half of the investment grade debt indices.
In February, several prominent companies were demoted to scrap, including Kraft Heinz, who is now the largest fallen angel in the developed world of all time. Department store chain
Macy’s
and automakers Ford and Renault also recently received unwanted ratings.
Recent data shows even more companies leaving a high-yield territory than entering it. But the current rout adds another danger: buyers of risky debt have evaporated, say fund managers. Once trading has restarted, it’s not Kraft Heinz who has the most to fear, but companies at the other end of the garbage spectrum. Funds are likely to reduce their risk by leaving the lowest-rated companies and turning to the fallen angels.
Kraft Heinz is now the largest fallen angel in the developed world.
Photo:
Scott Morgan / Reuters
Despite their steep decline, the latter tend to be large, relatively secure companies. Historically, they have turned out to be a wise investment, rebounding strongly in boom times and slightly softening the blow of the bear markets of 2000 and 2008 than other junk bonds.
This means that the riskiest paper can be left to dry, even if the global economy is ultimately doing better than expected.
The French container transport company CMA CGM, for example, has a lot of debt to refinance this year and the following year, and is in a sector exposed to the impact of the viral epidemic. His fate could test the confidence of fund managers in central banks. If they instead turn their backs on the weakest holdings in their portfolios, they could tip the rotten bond market into turmoil.
Either way, angels do not bring good news.
Write to Jon Sindreu at [email protected]
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