(Reuters) – Recent central bank bond-buying to calm market turmoil has breached the wall dividing top-grade debt from so-called junk-rated issues, raising the likelihood of the investment industry and even regulators eventually dismantling the barrier.
Central banks had until recently baulked at buying sub-investment grade debt — which is rated BB+ or lower — in their emergency programmes or accepting it as collateral, given the higher risk of default.
But with the coronavirus crisis roiling economies as well as markets, companies at the lower end of the investment-grade scale are at risk of losing those prized ratings and becoming so-called “fallen-angels”.
To prevent markets from seizing up if a slew of such ratings downgrades hits simultaneously, pushing billions of dollars of corporate debt to sub-investment grade, the Federal Reserve said last month it would take the revolutionary step of buying junk bonds, so long as they had been deemed investment grade on March 22.
That offered a lifeline to companies such as Ford (F.N), shielding it a from loss of funding after S&P cut it from BBB- to BB+ in late March. As Moody’s already assigned it a junk rating, $35 billion of the carmaker’s debt became ineligible for investment grade indexes, which are tracked by passive funds.
The Fed also said it would buy exchange-traded funds that hold high-yield debt, while the European Central Bank may also eventually adopt outright purchases of high-yield bonds. In March it included BB-/B1 rated Greek bonds in emergency asset-buying schemes and started accepting fallen angel debt as collateral last month.
A RECORD MONTH
The interventions unclogged frozen junk markets, with U.S. companies issuing more than $30 billion of new high-yield debt in April in one of the 10 busiest months on record. But longer-term ramifications are potentially bigger for a global investment industry where much capital allocation is still shaped by credit ratings.
Although some investment-grade fund managers have ventured into junk bonds since the 2008-9 financial crisis, the latest move may well turbo-charge the departure from ratings-defined investment processes, especially the cliff-edge division between high-yield and high-grade debt.
“What active managers have been doing since the financial crisis is increasing the flexibility of their mandates,” said James Vokins, head of investment-grade UK credit at Aviva Investors.
“(Central bank moves) should accelerate the momentum among active managers to go to clients and trustees for some kind of waiver on high-yield holdings so they are not forced to sell at the worst possible time.”
Reflecting the interest in investing across the ratings spectrum, fund rating firm Morningstar says it now tracks 206 European credit funds that can hold investment-grade (IG) as well as high-yield (HY), versus 180 five years ago.
Vokins said several of Aviva’s IG-only funds had the ability to hold some BB-rated credits.
“These are restrictions we asked to be slightly softened, to allow us hold the bonds a bit longer,” he said.
Legal & General Investment Management was among those going into the latest crisis with a number of funds able to hold 5%-20% in high-yield debt.
“We have seen an increasing desire for funds over the year to increase their flexibility to invest off-benchmark,” said portfolio manager Justin Onuekwusi.
For a graphic on Euro bond returns, click here
Nonetheless, ratings assessments still carry huge clout.
Indexes reserved for top-grade bonds and the passive funds that track them have little leeway and investors such as insurers face strict regulatory constraints on holding lower-rated securities.
Agencies say they merely score borrowers’ creditworthiness based on objective criteria, with boundaries between the BBB and BB baskets usually reinforced by markets. Fitch for example notes how investors rushed to sell BBB- debt during the current crisis as market stress built, even before a downgrade.
They also say their ratings aim to guide investors on default probabilities tmsnrt.rs/3b4l1Sz — for instance, the five-year default probability for credits on the lowest investment grade rung, BBB- is 2.8%, but 3.7% for BB+, the top junk category, according to S&P Global.
For a graphic on Default rates down the credit spectrum, click here
Among other hurdles, flexible strategy funds usually need to hire high-yield specialists for the additional legal and covenant analysis junk bond investing requires, Morningstar analyst Mara Dobrescu said.
And “while central bank actions have improved liquidity in high-yield, over the long-term it’s unlikely they will become as liquid as investment grade,” Dobrescu added.
That means investors, especially in closely regulated sectors, are unlikely to discount credit scores altogether.
Yet central bank support could be a powerful impetus for more flexibility, especially as yields, or returns, on high-grade debt tumble further and junk markets swell — S&P Global predicts around $640 billion of European and U.S. bonds will turn fallen angel this year.
“You are going to get some people that are forced to sell these bonds. But when you have another buyer and a buyer of last resort, it does make it easier (to hold fallen angels),” said Iain Stealey, international CIO, fixed income at JPMorgan Asset Management.
“You are going to see more of a broad remit that will start looking at high-yield. Once we can see light at the end of the tunnel it will happen.”
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