Rating Downgrades and the Effect of Fallen Angels

Posted on April 8, 2020

DDJ Capital Management recently recorded an audio market update with firm Founder, Portfolio Manager and CIO David Breazzano to discuss the extreme volatility and liquidity challenges in the high yield market. A question was asked about the downgrading of BBB-rated bonds (aka “fallen angels”) into the non-investment grade universe and what kinds of disruptions and opportunities this activity will create.

Listen to Mr. Breazzano’s response from the call on March 27, 2020. 
Listen to the DDJ Market Update with David Breazzano

If you are interested in listening to the full audiocast, please click here.

 

Prefer to read his response?  View below:   

“Well, the downgrading of BBBs into the high yield universe has begun and it will change the complexion of the high yield market first. Initially, it was Occidental Petroleum and now Ford Motor, two large debt issuers, being downgraded, and I believe Ford will now be one of the largest high yield issuers. And unfortunately, other BBB-rated companies are going to find their way into the high yield universe as well.

So what this does is creates a supply/demand imbalance. And it has really two components.  First, the original holders of the debt. The original holders of Occidental and Ford are now being forced to sell their paper because their mandates typically don't allow them to hold non-investment grade paper. So as it gets downgraded and comes into the high yield market, there are forced sellers so the price declines dramatically very quickly.

And then it affects the high yield market and buyers who have also been experiencing disruption in our traditional marketplace. We see an opportunity to buy a very good credit from a high yield perspective because these issuers were once investment grade companies that are of better quality than the average high yield issuer, but they're trading at yield and prices lower than comparables.

So it's an immediate opportunity, but we have to then sell something in our portfolio to have the cash to buy the new entrance into our market at these attractive prices. So all of a sudden, the supply of high yield increases. It's like a new issue just occurred and people in the high yield market are scrambling to get the cash to acquire this new entry into the marketplace at these attractive prices. And that requires some selling and disruption elsewhere in the market so that we can then digest this new relatively more attractive issue that is now high yield.

That puts pressure in the secondary high yield market, but also creates a wonderful opportunity going forward because the Occidental and Ford bonds, initially as they come in, are oversold and will likely generate attractive long-term returns once we're able to buy them – it creates a good long-term opportunity. But the immediate increase in supply pressures the secondary market in high yield. So in summary, there is a negative initial effect from the supply/demand aspect, but longer term, it creates a nice opportunity for future appreciation.”

 

Audiocast: High Yield Market Update with David Breazzano

 


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