Cover story – Fallen angels
date who could be forced sellers in the event of a downgrade. Watching the risks of potential downgrades closely is Anand Kwatra, an actuary at Phoenix. For the life consolidator and its peers in the insurance industry, holding downgraded debt could potentially become cash intensive, as Kwatra explains. “As part of the Solvency II capital requirements, we have to hold capital on these investments and a lot of our illiquids are very highly rated, AA or A. But on the liquid side we have a range of ratings, from AAA all the way down to BBB,” he says. “But like all insurance investors, we have very painful capital requirements for BBB assets. If we held a BBB-rated corporate bond with a 15-year maturity, we would have to hold a lot more capital than for an investment-grade bond.”
In addition, insurers are also prevented from taking benefits on improved spreads. “For us, the problem is really acute when BBBs get downgraded to high yield and the capital require- ments increase significantly. “That’s because the regulator puts a cap on the amount of ben- efit we can take, so the spread cannot exceed that of a BBB investment,” Kwatra says. “So even if the spread went up, the amount of spread we could take credit for in the balance sheet would be restricted. This is why a potential downgrade from BBB to sub-investment grade would be a key concern for insurers.” Kwatra’s team therefore monitors any potential downgrade risk and attempts to sell before the downgrade occurs. Similar challenges could also affect pension funds and fund managers with an investment-grade mandate, who might find themselves at the risk of becoming forced seller. But, as the saying goes, one man’s problem is another man’s opportunity. Kevin Wesbroom, a professional trustee at Capital Cranfield, says that for some pension fund investors, the grow- ing universe of fallen angels could be of interest. “On the one hand we have clients who are trying to generate stable income streams as part of a CDI-type strategy,” he adds. “Not surpris- ingly, if you buy things like government bonds, you would be lucky if you get positive income streams at all. “So inevitably, those kinds of people are forced to look further away to high-yield debt, and we are starting to see them trickle into these asset classes. “But it’s quite tricky. The whole point of CDI is that you want certainty of the cash-flows but unfortunately you can’t get the income of high yield without very serious default risks. “On the other side of the spectrum we have clients who are looking for return seeking assets and fallen angels would defi- nitely come under the category of alternative return seeking assets. But either way, the challenge is still the same. It is a bit like catching a falling knife. You might get it right, but you might well get your hands cut along the way,” Wesbroom warns.
22 | portfolio institutional November 2020 | issue 98
It is a bit like catching a falling knife. You might get it right, but you might well get your hands cut along the way.
Kevin Wesbroom, Capital Cranfield
If investors get it right, their bet could pay off. Annualised returns over the past five and 10 years illustrate that, in general, fallen angels tend to outperform the original high-yield uni- verse. This is a factor that has not escaped the attention of Stu- art Trow, credit strategist and trustee at the European Bank for Reconstruction and Development. “When you look at the risk-adjusted returns by probability of default ratings, almost invariably, BB-rated debt comes out at the sweet spot because it is still decent quality but there are a lot of people with investment-grade mandates who can’t touch it,” he say.
Liquidity and covenant risks Having said that, past performance is not always an indicator of future returns, particularly when the future continues to be dominated by the disastrous economic consequences of the pandemic. For Trow, size is a key concern when it comes to fallen angels, with the average size of issuers in the investment-grade uni- verse being far larger than that of the high-yield universe. One example is the downgrade of General Electric back in April. “People were really concerned about General Electric,” Trow says. “They have funding needs for billions and billions and if
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