Overview
In March of 2019, the Ford Motor Company, the world’s second biggest car producer, issued a €1.25 billion five-year bond, yielding 3.021 per cent. At the turn of 2020, that bond was trading far tighter in the secondary market, offering investors a yield of only 1.591 per cent, yet by the end of March that year the yield on the same paper had rocketed up to 11.67 per cent.
One of the causes was clear: the rating agencies Fitch and S&P had followed an earlier move by Moody’s and downgraded the firm’s credit rating by just one notch. This pushed Ford from an investment grade (IG) rating to become a high yield (HY) credit, causing its outstanding bonds to became ‘fallen angels’ - notes that had been issued as IG paper before being downgraded to HY. The yields right across its debt stack leapt.
Ford’s descent to HY was not unexpected. Its credit metrics and competitive positioning had been under pressure even before the downturn in vehicle demand caused by the Covid-19 pandemic dealt the final blow. But the company’s journey across the fine line between the highly rated IG universe and the theoretically far riskier world of high-yield shows just how different the conditions in these two markets can be – but also how porous the border between them is.
High yield bonds are sometimes colloquially - and unflatteringly - called “junk” bonds. The simplistic approach is to consider IG bonds as safe and HY as risky, but sometimes that misses the point: many of those sectors that have been through the worst have now emerged stronger on the other side. The sliding scale of risk can never be completely captured by credit ratings or third-party research providers, especially as companies move between ratings. But rising interest rates and a risk of recession are piling pressure on companies, increasing the risk of defaults. That makes it more important now than at any point in the past decade to spot those firms likely to be most exposed, irrespective of where they are on the ratings spectrum.
Herd mentality
Against this economic backdrop, the market reflex has been a flight to quality and a focus on more defensive assets. This makes sense at a basic level - if a recession is coming, and defaults rise, why not seek safety in what have been defined as the ‘safest’ companies?
But for investors with a willingness and ability to explore other parts of the market, there are options away from the crowd that offer ways to take advantage of some of the highest returns available in years, without drastically increasing the associated risk.
We believe that there are names available that can offer just these opportunities of high yield and relatively high quality, which is why credit selection is so important. Lower rated HY credits (rated B) have already outperformed their higher rated BB counterparts in the US for the year to date, with Chart 2 showing the strong returns across high-yielding buckets.
There are many other names like Ford which were solidly investment grade for a long time before slipping into HY territory. Many examples from the energy sector have since recovered IG status and two years of high oil prices have also cleared out debt burdens leaving oil companies in their most secure financial state in 20 years. We think the number which survives the next downturn will be higher than the ratings imply.
Another sector to consider, where some constituents cross the HY/IG border is European financials. Banks continue to raise many questions but, so far, European lenders (and regulators) seem to have the answers: this sector is better capitalised, more tightly regulated, and far less fragmented than its US counterpart. European bank stocks are up 10 per cent for the year to date, while even the returns on AT1 notes (excluding the impact of the Credit Suisse default) have recovered to stand flat on the year. US bank stocks for comparison are down around 8 per cent, and regional bank shares have fallen 25 per cent - evidence of how much the wrong allocations can hurt.
Lastly, given the nuance discussed above, it pays to examine the traditionally ‘safe’ industries more critically. Some have become lax over the cycle, with complacent management teams and their creditors allowing ever-increasing levels of leverage.
Back to Ford. Since being downgraded but having survived the ravages of the pandemic, the company’s credit story is looking far stronger. It has managed to reorganise its debt stack, issued green bonds to fund environmental projects, and in the US broken the record for the largest multi-tranche HY bond ever completed. Not bad for a load of junk.
