Some Energy Fallen Angels Find Their Wings

Many energy companies have been downgraded to junk status, but some will rebound faster than others as commodity prices recover. Investors tapping global bond markets for income should take note.

In the first quarter alone, more than $64 billion in US corporate bonds tumbled from investment grade to junk—already more than the $40 billion downgraded in 2015. Roughly three-quarters of this year’s downgrades were energy or metals-and-mining companies hit by the commodity price plunge.

Regardless of which country investors call home, the US high-yield bond market is a key source of income-generating opportunities, so this development calls for a response.

At first blush, it might seem prudent to avoid these “fallen angels,” as former investment-grade bonds are known. When the major ratings agencies strip a company of its investment-grade status, many investors conclude that the company’s future is bleak.

Too Much Supply, Too Little Demand

This is partly because many managers are prohibited from owning any subinvestment-grade bonds. If a bond drops to high yield, investment-grade-only portfolio managers have to sell it. This forced selling often causes prices to fall more than they should.

At the same time, willing buyers can be hard to find right after a bond falls to junk. Some investors are put off by the negative headlines. Some high-yield managers don’t spend much time analyzing investment-grade bonds, so it can take them longer to research a fallen angel before deciding whether or not to invest.

The result: a lot of fallen angels enter the high-yield universe undervalued relative to their credit fundamentals. But when investors refocus on fundamentals, many of these bonds end up outperforming original-issue high-yield bonds. Investors who can recognize the mispricing before the rest of the market does can potentially capitalize on these dynamics. But they need to act fast. As the following Display shows, fallen angels can start to recover quickly after a downgrade.

Not All Energy Bonds Are Alike

Here’s another thing that can work to investors’ advantage: fallen angels have a strong incentive to repair their balance sheets and restore their profitability. This makes them more likely to reduce debt, not add it. Historically, bonds that drop from BBB, the lowest rung on the investment-grade ladder, to BB, the strongest high-yield rating, have been more likely to migrate to investment grade than original-issue high-yield bonds.

Do some fallen angels eventually default? Of course. Some highly leveraged energy companies will likely suffer that fate in this cycle. Some of those that borrowed heavily to fund oil exploration and production—known as “upstream operations”—could face bankruptcy with oil prices hovering below $50 a barrel.

But other energy sector fallen angels are starting to find their wings. The market punished all energy-related firms when prices fell. But not all segments of the energy industry are equally sensitive to prices. Pipeline operators, oil-storage providers and downstream refiners can generally withstand prices in the $30–$50-a-barrel range. Buying some of these types of bonds at a steep discount earlier this year would have been a steal.

Preparation and Flexibility

We still see opportunities to take advantage of this fallen-angel effect. US credit markets are in the late stages of the credit cycle, and many investment-grade bonds are trading at levels that imply more downgrades are imminent. To capitalize on these opportunities, investors have to be prepared ahead of time. That means conducting extensive credit analysis of potential fallen angels before they fall. Investors who do that will be in a position to move quickly on those fallen angels that appear to offer good value.

It’s also important to be flexible. Many market participants draw a hard line between the investment-grade and high-yield categories and stick to one side of it. But excessively rigid investment approaches often limit potential returns. In our view, it’s better to put yourself in a position to take advantage of mispriced securities, wherever you find them.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

Director—High Yield and Investment-Grade Credit

Gershon M. Distenfeld is Senior Vice President and Director of High Yield and Investment-Grade Credit at AB, responsible for overseeing the investment strategy and management of all investment-grade and high-yield corporate bond portfolios and associated portfolio-management teams. Strategies under his purview span the credit and risk spectrum, from short-duration investment-grade corporate bond portfolios to regional and global high-yield portfolios, encompassing a range of investment approaches, objectives and alpha targets, from income-oriented buy-and-hold strategies to active multi-sector total return strategies, and including both publicly traded securities and private placements in developed and emerging markets. Distenfeld also co-manages AB’s award-winning High Income Fund, recently named “Best Fund over 10 Years” by Lipper from 2012 to 2015, and the award-winning Global High Yield and American Income portfolios, flagship fixed-income funds on the firm’s Luxembourg-domiciled fund platform for non-US investors. He also designed and is one of the lead portfolio managers for AB’s Multi-Sector Credit Strategy, which invests across investment-grade and high-yield credit sectors globally. Distenfeld is the author of a number of published papers, including one on high-yield bonds being attractive substitutes for equities and another on the often-misunderstood differences between high-yield bonds and loans. His blog “High Yield Won’t Bubble Over” (January 2013) is one of AB’s all-time most-read blogs. Distenfeld joined AB in 1998 as a fixed-income business analyst, and served as a high-yield trader (1999–2002) and high-yield portfolio manager (2002–2006) before being named Director of High Yield in 2006. He began his career as an operations analyst supporting Emerging Markets Debt at Lehman Brothers. Distenfeld holds a BS in finance from the Sy Syms School of Business at Yeshiva University, and is a CFA charterholder. Location: New York.