Fallen Angels

The credit-rating agencies have noticed the rapid economic collapse caused by the coronavirus and are now pushing many large companies over the edge from BBB (the lowest level of “investment grade”) into lower tiers. Since the beginning of February, U.S. corporate debt with a face value of about $120 billion has been downgraded to “junk” status. These handful of so-called fallen angels, including Ford Motor, Kraft Heinz, Occidental Petroleum, and Macy’s, are having a big impact on the overall high yield market.

That's because investment-grade issuers structure their borrowing differently than the lower-rated borrowers used to paying high prices for bond financing, as Barron’s Alex Scaggs explains:

As a general rule, it is easier for higher-rated companies to sell longer-dated debt, because investors are willing to lend to them for longer periods of time. Maturities and durations of investment-grade bonds are greater than those of junk-rated debt; the investment-grade bond index’s maturity is 11 years, while the maturity of the high-yield index is six years, according to ICE BofA Indices.

So when investment-grade companies get downgraded to junk, joining the ranks of firms known as “fallen angels,” they bring more long-dated debt into the high-yield bond market with them.

Kraft Heinz (ticker: KHC), for example, has $9.3 billion of bonds maturing in 20 years or longer. When it joined the high-yield bond index at the start of March, it single-handedly more than doubled the duration of the high-yield food, beverage and tobacco sector.

Expect this process to continue.

Before the recent spate of downgrades, the face value of the BBB market ($3.4 trillion) was about three times the face value of the entire high yield market ($1.2 trillion). That creates a lot of potential new entrants to alter the composition of the junk bond indexes. It also creates complications for the Federal Reserve's plan to support the investment-grade bond market if many of those borrowers suddenly suffer a loss of creditworthiness.