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Will high yield be a landing ground for more fallen angels?

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      By Stephen C. Concannon, CFACo-Director of High Yield Bonds, Portfolio Manager, Eaton Vance Management and Will ReardonInstitutional Portfolio Manager, High Yield

      Boston - In early March, bonds issued by Kraft Heinz Co. (KHC) will migrate from investment-grade to high-yield indexes, following Fitch and Standard & Poor's cut to the company's credit rating by one notch from BBB- to BB+ on February 14. Not surprisingly, the downgrade of a high-profile issuer has renewed talk of "fallen angels," the name given to a bond that sees its rating slip from investment grade to high yield.

      In this blog post we provide our views on how the downgrade of KHC bonds may impact the high-yield market and discuss why we believe fears of fallen angels are overdone.  

      KHC's bonds and the high-yield market

      The rating downgrade will bring approximately US$23.5 billion of bonds into the high yield universe — the highest fallen-angel influx since 2005, when auto manufacturers General Motors (US$44.1 billion) and Ford Motor Company (US$42.7 billion) were downgraded.1

      However, the most notable impact will come from the longer duration profile of KHC's bonds. Duration, a measure of a debt instrument's price sensitivity to changes in interest rates, is typically shorter for high-yield issuers. On a duration-weighted basis, the company will become the largest issuer, accounting for approximately 5% of the total duration on the Bloomberg Barclays US Corporate High Yield Bond Index. KHC bonds will also dominate the long end of the index, as the longest-dated bond in the company's debt stack matures in 2049 and US$14 billion in bonds have a maturity beyond 10 years.

      In terms of performance, we are not overly concerned about how KHC's bonds will affect the asset class over the intermediate term. On average, fallen angels briefly underperform their high-yield peers following the initial downgrade, but later close this performance gap after forced selling from investment-grade funds abates. Furthermore, given KHC's cash on the balance sheet and ability to generate positive free cash flow, we believe it is unlikely that the company will come to market with a new debt offering in the near future.

      Rising stars and fallen angels

      Fallen-angel risk has not disappeared since October 2018 when General Electric Co. (GE) became a possible downgrade candidate (after Moody's downgraded the company's debt). However, beyond a few high-profile downgrades, the trends for ratings changes have been far less alarming. For instance, the total number of downgrades into high-yield territory fell last year from 19 to 12, while the US dollar value of fallen-angel bonds reached a 20-year low at US$17 billion. At the same time, rising stars outpaced fallen angels by more than double, with a total of 26 in 2019.2

      2020_02_24_HYIndicies

      Bottom line: Looking ahead, there is always potential for fallen angels to enter the high-yield market and we believe that it is natural at this point in the cycle to see an elevation in downgrade activity. However, most investment-grade issuers can and do ward off the threat of a rating cut by reducing leverage, paring back equity-friendly activity or selling assets to reduce debt. This has not changed and we believe that the current economic environment still is supportive for issuers to effectively manage leverage levels.