(Bloomberg Businessweek) -- For decades, credit rating agencies have unintentionally provided bond investors with an almost guaranteed way to turn a profit: When the firms demote companies from investment-grade, many money managers are forced to sell, because they have mandates forbidding them from owning junk debt. Such sales typically happen fast, pushing prices below those for bonds with similar ratings—and people who face no such restrictions rush in to buy, aiming to benefit as the debt returns to equilibrium.
The Covid-19 pandemic slammed the brakes on the strategy, called fallen angel investing. As companies recovered from the economic shock of global lockdowns, balance sheets improved, leading to far more upgrades than downgrades. Bloomberg’s US fallen angels index is about a quarter the size it was in 2020, with fewer companies than at any point since it was introduced in 2005.
Now, with high interest rates weighing on balance sheets, fans of fallen angels are predicting a slew of opportunities. Bloomberg Intelligence estimates that the value of bonds from US companies at risk of such downgrades has risen to $93 billion, from $19 billion in January. “The fallen angels are coming,” says Manuel Hayes, a portfolio manager at Insight Investment who’s forecasting about $50 billion of fallen angels in the next 12 months. “We couldn’t be more excited.”
Companies that have recently been downgraded from investment-grade generally have stronger balance sheets than those already deemed junk, so on top of the potential price appreciation, money managers also get a better-quality investment. The strategy tends to see a particularly big boost during recessions, when lots of companies are downgraded at once. Despite the global selloff in early August, such a scenario remains unlikely this time around. Still, after the long winter for fallen angels, investors are excited for any sign of revival, says Ashton Parker, who runs a fallen angel fund at Switzerland’s Lombard Odier Investment Managers. “Essentially it’s a case of a normalization or catch-up,” he says.
There are also signs inflation is starting to weigh on consumer spending, causing more angels to tumble. Drugstore chain Walgreens Boots Alliance Inc. became a fallen angel in July after S&P Global Ratings downgraded it. And Moody’s Ratings says it’s considering cutting Paramount Global’s rating to junk after the studio agreed to sell itself to Skydance Media LLC. “As the economy slows, downgrades are unavoidable,” says Althea Spinozzi, head of fixed-income strategy at Saxo Bank. “For sure we are going to see more fallen angels.”
Downgrades often cover multiple companies in a single sector, which can leave fallen angel investors with too much concentration in one part of the market. During the pandemic it was airlines and hospitality, and in 2016 many energy companies were downgraded after a slump in oil prices. This time around, many fallen angels will come from telecommunications, cable and real estate, “segments that are somewhat challenged fundamentally,” says Mike Scott, head of global high yield at Man Group Plc.
Another risk for those investors is what insiders call falling knives—companies that just keep on being downgraded until they default on their debt, slashing holes in portfolios on their way to the bottom. While that highlights the peril inherent in the strategy, fans say it’s sound. Even after accounting for such mishaps, Bloomberg’s fallen angel index has outperformed its broader junk bond counterpart over the long term.
Bank of America Corp. researchers say the proportion of bonds on watch for a downgrade to junk this year surpassed potential upgrades for the first time since 2021. Two of those companies—Boeing Co. and Charter Communications Inc.—would be among the biggest fallen angels in history, says BofA credit strategist Yuri Seliger. “We just went through a period of very few downgrades,” he says. “But there are signs that maybe the risk of downgrades is now rising.” —With Cecile Gutscher and Abhinav Ramnarayan
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