From ZeroHedge, November 22:
The first time the thesis of shorting potential "fallen angel" bonds -
those rated BBB on the lowest cusp of investment grade, and with a high
likelihood of being cut to junk - was openly publicized was exactly one year ago
(back when the single-digit VIX was all the rage and not a cloud was
seen on the credit horizon), when we revealed that Horseman Capital's
Russell Clark believed that the next major source of alpha would be shorting fallen angel bonds. This is what he said then:
The International Monetary Fund produces Global Financial Stability
Reports. The stand out report for me was the April 2008 report that
highlighted Eastern European banks vulnerability to wholesale funding. I
shorted many of the banks named in the report. Most fell 70% to 90%
subsequently.
What does the most recent issue of the Global Financial Stability Report have to say? It notes that BBB bonds now make up nearly 50% of the index of investment grade bonds, an all time high. BBB
bonds are only one notch above high yield, and are at the greatest risk
of becoming fallen angels, that is bonds that were investment grade
when issued, but subsequently get downgraded to below investment grade,
or what is known these days as high yield. It then points out that investors have never been more at risk of capital loss if yields were to rise. In
addition, it notes volatility targeting investors will mechanically
increase leverage as volatility drops, with variable annuities investors
having little flexibility to deviate from target volatility. Another
interesting point was that mutual fund share of the high yield market in
the US have risen from 17% in 2008 to 30% today, and notes that
investors outflows have become much more sensitive to losses than they
used to be.
So my favourite research (love the price!) is telling me that US investment grade debt is very low quality, and could produce some large fallen angels. It
then goes on to tell me that mutual funds are much larger in the high
yield market than they used to be. It also tells me low rates means the
capital losses are much higher than they used to be. And that investors
in high yield mutual funds are much flightier than they used to be! Essentially
the IMF are telling me that if you get a large enough fallen angel, the
high yield market will freak out, and volatility will spike causing
volatility targeting investors to dump leveraged positions. Sounds good
to me...
Back then, Horseman was one of the handful of funds targeting fallen angels.
Fast forward to today when discussing and shorting BBB credits, i.e.
tomorrow's fallen angels, especially in the aftermath of the recent
collapse of GE and PG&E bonds, is all the rage.
And while it usually takes the peanut gallery about a year to catch
up to the thought leaders by which point the idea is no longer relevant
as it has been fully priced in, this case is the one case that may be
the exception to the rule, as there is indeed good reason to be worried
about the future, because as we discussed last month, the Next Bond Crisis will be the result of "Over $1 Trillion In Bonds Risk Cut To Junk Once Cycle Turns."
To be sure, there is more than enough dry powder to start said
crisis: as the following Deutsche Bank chart shows, the BBB-rated debt
cohort has seen a massive increase in the past decade, with low-IG rated
companies generously issuing debt to fund trillions in stock buybacks,
or to acquire other companies, and now BBB debt accounts for nearly 60% of the entire $6.4 trillion US investment grade space, with a similar portion for Europe.
And while the market now fully agrees that the next credit crisis
will be sparked by the thunderous falling of "angels" into junk hell,
with distressed investing stalwarts Oaktree Capital recently joining the bandwagon of fallen angel hunters, saying that the fund "expects to see a flood of troubled credits topping $1 trillion as rising interest rates overwhelm low-quality loans and bonds", the one question left is how much of this BBB paper is likely to be downgraded?
Or, as one might say, that is the 6.4 trillion dollar question (the size of the US investment grade corporate bond sector).
To answer that question, Deutsche Bank credit strategist Nick Burns looked at the historical record to assess the normal attrition rate for BBBs to HY. The chart below looks at the proportion of BBBs that have been downgraded each year, and while this has fallen towards historically low levels in recent years, this is unlikely to be sustainable, particularly if the global economy slows
down as it will starting in 2019 and likely careening into a recession in 2020 as is now the prevailing consensus....MORE
