Which High Yield Bonds Are Ready to Reach Investment Grade? | Lord Abbett
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Market View

Key trends may combine to boost the number of “rising stars.” Here are the implications for investors in U.S. high yield bonds.

Read time: 3 minutes

After a strong showing in the first seven months of 2021, the U.S. high yield bond market, as represented by the ICE BofA U.S. High Yield Constrained Index, took a pause in mid-August amid headlines on the spread of the Delta variant and possible moves by the U.S. Federal Reserve (Fed) to “taper” its bond purchases. Despite this recent, slight pullback, the index remains in firmly positive territory for 2021, due in part to more favorable trends in credit quality—especially the pace of upgrades from major rating agencies, which has created the potential for more to issuers achieve “rising star” status.

High Yield Bonds: Watching the Skies

Fallen angels are defined as issuers that have been downgraded from investment-grade status to below investment grade.

Rising stars are defined as issuers upgraded to investment grade from below investment grade.

Source: S&P Global.

Last year, companies across all industries faced increasing downgrade pressure because of economic shutdowns caused by the COVID-19 pandemic. For perspective, in 2020, 53% of high yield bond issuers were downgraded, which compares to a previous high of 45% in 2009 in response to the Global Financial Crisis (GFC). This downgrade pressure was not limited to high yield bonds. Many companies that were previously investment grade fell into “fallen angel” status as their bonds were ultimately downgraded to speculative grade. In 2020, the volume of U.S. issuers moving to fallen angel status totaled a record $214 billion, greater than the amount recorded during and after the GFC.

However, the script flipped at the turn of the calendar year as the rate of upgrades in 2021 (through June 30) has now blown past the rate of downgrades. This is due in large part to the global economic recovery that has helped corporations’ credit metrics recover, as well as an active new issue market that allowed them to address upcoming liquidity needs. July was the seventh consecutive month where upgrades outpaced downgrades across the board. Furthermore, $354 billion in issuance was upgraded compared to a total of $132 billion that was downgraded.

Figure 1 shows that the upgrade to downgrade ratio has been higher than 1.0 since the turn of the calendar year, a vast improvement compared to 2020 and a clear indicator of a much better credit environment.

 

Figure 1. Ratings Downgrades Have Declined to Their Lowest Point Since December 2018

Source: JP Morgan. Data as of July 31, 2021.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

One factor driving upgrade activity across the credit spectrum is the fact that management teams have moved to bolster their balance sheets. Companies have built huge cash positions over the past several years, with total liquid assets at nonfinancial companies totaling $6.4 trillion through the first quarter of 2021, according to the Fed. This amount is about 50% higher than it was in 2018, as companies have taken advantage of historically low interest rates that the Fed has maintained since the GFC to weather any residual economic softness through an active new issue market.

Upgrade pressure has also been driven by a continued decline in expectations of future defaults. The low default rate is partly due to high yield indexes’ marginal improvement in credit quality. The pandemic resulted in a high number of companies moving to fallen angel status from investment grade, yet many issuers have now recovered and are considered rising star candidates. Per JP Morgan data, the trailing 12-month default rate is well below pre-pandemic levels, and year-to-date default volume is on pace to be the lowest total annual amount since 2013.

 

Figure 2. Key Default Metrics Have Shown Steady Improvement in 2021

*Year to date through June 30.
Source: JP Morgan (left panel); JP Morgan and Moody’s Investors Service (right panel). Data as of June 30, 2021 (left panel) and July 31, 2021 (right panel). LTM=Last 12 months.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

This strong fundamental backdrop has directly translated into a higher volume of rising stars. Year-to-date, $22.5 billion of high yield debt reached rising star status versus a mere $2.7 billion of investment- grade issuers moving in the opposite direction. Despite the already robust volume in rising stars, we think the momentum for more issuers to ascend to investment grade is likely to continue. As of August 20, there was $424 billion of high yield bonds rated BB+/Ba1 by at least one of the three major rating agencies (S&P, Moody’s, and Fitch). Of that amount, $140 billion (or 33%) was on positive watch/outlook by at least one of the three agencies, indicating the chance for these issuers to move to investment grade at some point in the future. More specifically, according to JP Morgan, $75 billion in speculative debt is on the cusp of rising to investment-grade status in the intermediate term.

A Final Word

For the remainder of 2021, the current economic landscape appears to be favorable for high yield issuers, supported by a return to trend U.S. GDP growth and a constructive corporate earnings outlook, along with continued, low projected default rates. As for investment opportunities, select fallen angels turned rising stars may be a source of outperformance as many of these issuers are poised to potentially regain investment-grade status over the coming year or two. We think the net migration of issuers into investment grade from high yield is also likely to serve as a supportive technical driver for the broader leveraged credit markets, given the relative dearth of attractive yields elsewhere in fixed income. 

 

Unless otherwise noted, all discussions are based on U.S. markets and U.S. monetary and fiscal policies.

Asset allocation or diversification does not guarantee a profit or protect against loss in declining markets.

No investing strategy can overcome all market volatility or guarantee future results.

The value of investments and any income from them is not guaranteed and may fall as well as rise, and an investor may not get back the amount originally invested. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.

Market forecasts and projections are based on current market conditions and are subject to change without notice.

Projections should not be considered a guarantee.

Fixed-Income Investing Risks

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. 

The credit quality of fixed-income securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

This material may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The views and opinions expressed are as of the date of publication and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions and Lord Abbett disclaims any responsibility to update such views. Lord Abbett cannot be responsible for any direct or incidental loss incurred by applying any of the information offered.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

Please consult your investment professional for additional information concerning your specific situation.

Glossary & Index Definitions

Tapering refers to the gradual slowing of the pace of the U.S. Federal Reserve’s large-scale asset purchases.

The ICE BofAML U.S. High Yield Constrained Index tracks the performance of U.S. dollar-denominated, below- investment-grade, corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have a below- investment-grade rating (based on an average of Moody’s, S&P, and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed-coupon schedule and a minimum amount outstanding of $250 million.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

This material is the copyright © 2021 of Lord, Abbett & Co. LLC. All Rights Reserved.  

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