Fallen angels – Cover story


the market started to get cold feet, you just couldn’t fund these volumes in the high-yield market in the same way that the investment-grade market could.”


The difference in size has implications for liquidity, Trow adds. “When market conditions are good, you can get bigger deals done, even sub-benchmark deals (where the issuer is not included in a benchmark index). To be included in the major indices, which a lot of fund managers like, the issuance vol- ume would have to be at least 500 million. “If the market is really strong, like it was a month or two ago, they would be far more inclined to go for the smaller deals because they felt they could get a bit more yield out of it,” he adds. “But as soon as things get a bit difficult, you want the safety of liquidity. If you want to be able to sell, with a bench- marked deal, you would know there’s a market there. But if it’s a 100 million deal and you’ve got 50 of it, there’s not that many people to sell it to.”


These liquidity risks might not be an immediate concern for investors who intend to hold the debt on a buy-and hold basis as part of a CDI strategy. They should, however, be considered by return-seeking investors, Wesbroom says. “It’s one thing to get into these things, another to get out of them,” he adds. Another factor to consider when investing in fallen angels is the covenant package. Unlike traditional high-yield bonds, which tend to face more stringent covenant requirements, investment-grade companies tend to face less stringent rules to underwrite their debt, even if their overall credit rating changes. For example, a company might still be able to sell some of its assets or pay dividends and make investments out- side the group,


despite its credit standards having


deteriorated. In the case of Carnival Cruises, this meant that the cruise ship giant was able to sell part of its fleet throughout the year, de- spite its bonds being secured against the assets. Similarly, a re- tail giant like Marks & Spencer, having previously been labelled investment grade, might be able to sell some of its stores to generate additional cash, at a risk to its creditors. For Wesbroom, the additional factor of the pandemic means that default risks have become harder to predict. “The chal- lenge is, how do you spot the companies that will survive from the ones that will go to the wall?” he adds. “It is a different type of analysis from the one many managers have been used to doing. It requires making some tough judgement calls if a business will be around post-Covid or not.”


Treading carefully For investors who can stomach this risk, fallen angels might have something to offer, Wesbroom and Trow argue, but inves- tors should be careful how and where to include them in their portfolio.


Issue 98 | November 2020 | portfolio institutional | 23


“Fallen angels could be part of a barbell strategy, whereby you balance the really risky stuff with much safer assets,” Trow says. “I think that could work.” For Wesbroom, part of the danger is that investors are increas- ingly desperate to secure returns. “When half of the available bond universe is trading in negative territory, people start to get desperate to find things to invest in,” he says. “The danger here is that in a lot of cases managers are starting to get into areas where they haven’t got the skills to make these quite complex evaluations,” Wesbroom adds. “I would be very nervous as a buyer of services. I would want to see that the manager in question has a fairly serious track record rather than just seeing it as the next shiny thing they’re chasing after.” He concludes that high yield, and fallen angels in particular, is an area best kept to investors with expertise. “This is very much an area for external managers. It is an area where I would have more confidence in a fiduciary manager being able to do the research necessary to identify either the right managers or the underlying assets. “It’s a classic illustration of where you need in-depth analysis that I believe most fiduciary managers would bring to the pro- cess. You would have to be either very brave or foolish to try and go into this on your own.”


Fallen angels could be part of a barbell strategy, whereby you balance the really risky stuff with much safer assets.


Stuart Trow, European Bank for Reconstruction and Development


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