Look Out For Falling Angels

September 08, 2016 | Matt Anderson, CFA, Assistant Vice President, Client Service

Over the past year, many bonds from energy and metal/minerals issuers which previously held investment grade ratings were reduced to junk bond status, commonly known as fallen angels. These include Freeport-McMoRan, the largest copper producer in the world and Chesapeake Energy, the second-largest gas producer in the U.S. This week’s chart examines this unprecedented phenomenon. Fallen angels now account for a mind-boggling 42% of the energy and metal/minerals constituents in the Credit Suisse High Yield Index. With this influx of fallen angels, energy and metal/minerals now make up about 21% of the high yield index, up from 15% in February.

Many investment grade strategies, as well as their institutional investors, have been forced to sell these fallen angels because of investment policy guidelines, temporarily depressing prices and thus presenting cheaper than normal buying opportunities. Furthermore, the shift of bonds from investment grade to high yield has created a unique challenge for the team dynamics of investment managers. Investment grade research analysts are losing issuers to cover since many of them have been downgraded while high yield research analysts are now responsible for covering more issuers. Some investment managers are even transferring investment grade analysts to high yield positions because they are already familiar with the bonds that have become fallen angels.

Marquette recommends that investors maintain their high yield bond allocations. Because of these temporarily depressed prices and the change in name coverage within investment management teams, inefficiencies and opportunities have been created in this cross-over section of the bond market. However, there are risks. We should continue to see an increase in the default rate for high yield energy and metals/minerals issuers. Given lower commodity prices across the globe, while costs have been reduced for pumping oil or mining for metals, the energy and metal/minerals industries have yet to make any significant improvements. Many companies are still filing for bankruptcy, even though oil prices are beginning to slightly rebound. Ultimately, the current opportunities should outweigh these risks, but volatility in the high yield market will likely remain elevated for the foreseeable future.