Over the past year, a surge of investors drove high-yield bond prices back to pre-pandemic levels. By many measures, high-yield bonds now appear expensive. But a wave of rising stars—bonds moving to investment-grade ratings from below investment grade—may signal that there’s more happening in credit markets than meets the eye.
Credit Is Primed for Upgrades
As the country went into lockdown, credit markets braced themselves for a wave of fallen angels—investment-grade credits dropping to high-yield ratings. But as the dust settles and the economy rebounds, catastrophic assumptions have proven too extreme. We believe this has started an upgrade cycle in credit markets.
Potential rising stars have attracted attention, partly because credits reaching investment grade have a much larger base of potential buyers, providing meaningful future price support. But all credit improvements are material—whether it’s a rising star or an upgrade from CCC to B, and regardless of whether recognized by rating agencies or just by market participants. Why? Because credit improvement generally leads to rising bond prices.
The earlier an investor can ferret out and buy an improving credit with a potential upgrade on the way, the better. As more and more investors believe a bond is approaching a rating upgrade, they bid up the price ahead of time, compressing the bond’s yield spread over investment grade. Most of that spread compression happens before the upgrade (Display).
For some investors, such as insurance companies, the ability to identify BB-rated bonds primed for an upgrade can bring significant additional benefits. Insurance companies are sensitive to the credit rating of bonds they purchase due to capital requirements, so they usually strictly limit their high-yield holdings. But if they can identify BB-rated bonds destined for an upgrade early on, they get to book the higher yields, realize the price appreciation and get better capital treatment after the upgrade. The potential for a double dip should increase insurance companies’ appetite for juicier high-yield offerings.
Research Is Necessary When Markets Are in Flux
The transition from a downgrade cycle to an upgrade cycle takes time. Rating agencies are often slow to adjust ratings, and market participants must fully understand the new and unfolding landscape before jumping in with both feet. To fully appreciate the opportunities and pitfalls, diligent credit research during periods of change is crucial.
Consider the makeup of the high-yield market. Distressed credit—bonds teetering on the brink of default—became a concern in late 2018, causing spreads to widen. Then the pandemic made it impossible for the weakest companies to continue. In 2020, over 30% of CCC-rated bonds defaulted.
At the same time, another historical anomaly played out at the upper end of the high-yield spectrum. More than US$200 billion of fallen angels tumbled out of the investment-grade universe into the BB tier of the high-yield market. As a result, today’s high-yield market is higher quality than before the pandemic, and spreads appear tighter (Display).
While high yield improved its lot through the pandemic, some investment-grade issuers rated A or above took on more debt to maintain flexibility through the crisis. There wasn’t much reason not to increase debt, since interest costs would be only slightly higher if ratings were to fall to BBB. And as long as their ratings stayed within investment grade, companies would still have access to markets.
These crosscurrent movements, up and down, reinforce the critical role of deep and well-integrated research across the high-yield and investment-grade markets. Investors who can quickly recognize a credit poised to move will have an advantage over those who wait for official upgrades and downgrades.
Credit Markets Will Continue to Evolve
The pandemic has been destructive and disruptive. The key for investors is discerning the difference between permanent and temporary changes.
We think some pandemic-related changes, such as consumer shopping habits, may be more enduring than typical cyclical shifts. For example, mid-pandemic, the need to personally select tomatoes at the grocery store gave way to the convenience and safety of grocery delivery. Consumers also cut out the middleman on some products, buying directly from the maker. Higher direct-to-consumer sales on consumer products could mean lower distribution costs in the future.
Communications companies may benefit as workers require more internet bandwidth to work from home, at least part time, permanently. And as businesses increasingly adopt digitized processes, including customer and supply-chain interactions, tech companies are rising to meet the demand.
As credit markets rebound from overly pessimistic COVID-19 forecasts, there’s more shifting and changing under the surface than meets the eye. And we expect it will take some time for the dust to settle. While attention may focus on rising stars and fallen angels, investors who look beyond the obvious will realize the pandemic has created a credit universe full of potential stars-in-the-making.
- Robert Hopper
- Director—High Yield and Emerging Market Corporate Credit Research
- Susan Hutman
- Director—Investment Grade Corporate Credit Research