What happens when ‘angels fall’?

Yuliya Baranova, Harry Goodacre and Jamie Semark.

Over the past 20 years, the share of outstanding corporate bonds rated BBB, the lowest investment-grade rating, has more than doubled. This has left a large volume of securities on the edge of a cliff, from which they could drop to a high-yield rating and become so-called ‘fallen angels’. Some investors may be forced to sell ‘fallen angels’, for example if their mandate prevents them from holding high-yield bonds. And this selling pressure could push bond prices down, beyond levels consistent with the downgrade news. In this post we explore the impact that sales of ‘fallen angels’ could have on market functioning, finding that they could test the liquidity of the sterling high-yield corporate bond market.

There might be multiple reasons behind the increased share of investment-grade bonds rated BBB, including an increase in debt-funded mergers and acquisitions, post-crisis changes to credit rating methodologies, and a switch from bank to bond financing.  And over the past couple of years, the issue of ‘fallen angels’ has been gaining increased attention internationally: from the financial press, market analysts, and policy institutions. These commentators have noted that there is now a risk of much larger downgrades from BBB to high-yield than in previous credit cycles.

Focusing on the sterling corporate bond market, where, similar to other regions, BBB-rated corporate bonds are gaining market share, we take the analysis a step further by quantifying the potential size of such downgrade-triggered sales and exploring the impact that they might have on market functioning.

The size of the sterling investment-grade corporate bond market, as proxied by the market value of a representative index, has increased six-fold since 1998 to currently stand at £375 billion. Over the same period, the share of BBB-rated bonds in the market has increased from 8% to 50% (Chart 1). This  leaves the market value of the sterling BBB market four times greater than that in 2008 and eight times that in 2002 (Chart 2).

Chart 1: Sterling investment-grade corporate bond index by credit rating

Sources: ICE BofAML and author calculations.

Chart 2: Market value of BBB-rated sterling corporate bonds

Sources: ICE BofAML and author calculations.

Were the credit cycle to turn and downgrade rates to rise, the market value of ‘fallen angels’ would be much larger than that seen in past credit ‘busts’. Downgrades as such are not necessarily a cause for concern. Credit rating changes happen regularly, reflecting new company fundamentals. But a wave of downgrades could be an issue if investors have incentives that lead them to sell downgraded securities, especially if market liquidity is insufficient to absorb those sales. This could push the prices of downgraded securities below the new fundamental values, triggering further losses for their holders.   

One reason such sales might be triggered is due to certain market participants having limits on the amount of high-yield securities they can hold. For example, open-ended index funds that track an investment-grade corporate bond index are required to follow the index as closely as possible and would be forced to sell downgraded securities that fall out of the index. Other investors, with less stringent mandates, may still be incentivised to sell. In particular, actively managed investment-grade corporate bond funds, though not required to sell downgraded bonds, may prefer to do so to avoid outflows associated with poor performance, either relative to peer funds or a benchmark index. For certain insurers, holding lower-rated securities attracts higher capital charges (eg under Solvency II), so a large amount of downgrades might prompt insurers to sell these downgraded bonds.  

To explore the impact of a large volume of sales into the sterling high-yield market, we consider a ‘severe but plausible’ scenario in which the share of BBB-rated corporate bonds downgraded to high-yield rises from the historical average of 5% per year (Chart 3 left-hand bar) to the c. 11% level (Chart 3 right-hand bar) seen in past credit ‘busts’, such as those in 2002 and 2008. By looking at sterling investment-grade corporate bond funds’ and UK insurers’ total exposures to BBB-rated sterling bonds, we estimate that in such a scenario they could potentially sell more than £10 billion of ‘fallen angels’, assuming they liquidate all the downgraded securities that they hold. Insurers (£3.3bn) contribute the biggest increase in sales as the downgrade rate goes up, followed by Active funds (£1.5bn) and Index funds (£0.3bn).

Chart 3: Potential sales of ‘fallen angels’

Sources: ICE BofAML, Morningstar, Solvency II submissions and author calculations.

The extent to which this £10 billion of sales could have financial stability implications would depend on the ability of the high-yield market to absorb them. In recent years there have been signs of reduced liquidity in corporate bond markets. In particular, turnover ratios – market trading volumes relative to amount outstanding – in the sterling high-yield corporate bond market are now three times lower than those in 2012. And more crucially, there is evidence that dealers, on which investors are heavily reliant for provision of liquidity in corporate bond markets, now have less capacity to intermediate compared to pre-crisis. For example, in response to demand for liquidity by clients, US high-yield dealer inventories now expand by less and prices fall by more. This raises the question: will dealers be able to catch the angels’ fall?

To answer it, we compare potential bond sales triggered by downgrades to measures of dealers’ ability to absorb them. We use two measures: (i) the total volume of sterling high-yield bonds purchased by dealers from clients over an average month since 2011 and (ii) monthly changes in dealers’ inventories of sterling high-yield bonds since 2011. We calculate these measures using the transaction level data provided by the Financial Conduct Authority (FCA). We also make a ‘severe but plausible’ assumption that around a quarter of the 11% annual downgrade rate is concentrated within one month – as was the case in 2008. Taking one quarter of the £10bn of sales shown in Chart 3 implies that under this scenario more than £2 billion of high-yield bonds could be sold in one month (Chart 4).

These sales would be equivalent to more than half of the total volume of sterling high-yield bonds purchased by dealers from clients over an average month (Chart 4). Although the ‘fallen angel’ effect on its own is unlikely to overwhelm the ability of the high-yield market to absorb asset sales, it materially increases the demand for dealer intermediation. And were other selling behaviour – that not directly triggered by the downgrades – to occur in the high-yield market at the same time (eg due to investment fund outflows or a general decrease in risk appetite), market functioning could become impaired, causing asset prices to fall below the fundamental values. If during this time dealers’ estimated willingness to buy were to fall to the lowest level in our dataset – where monthly purchases are 20% below average – investors would find it even harder to quickly sell assets without incurring material losses.

In a stress scenario, dealers will likely find it more challenging to find end buyers for corporate bonds. Hence market functioning is likely to become reliant on dealers’ willingness to increase their inventories. We find that under our stress scenario, asset sales could be roughly five times bigger than the largest aggregate monthly increase in sterling high-yield corporate bond inventories of global major dealers, as observed since 2011 (Chart 4). Hence, these sales of ‘fallen angels’ alone could test the ability of dealers to intermediate the sterling high-yield corporate bond market and result in large and disorderly adverse moves in high-yield bond prices. Such price moves have in the past caused losses on the balance sheets of various investors, including systemically important banks and insurers. This in turn prompted them to sell more risky assets, pushing prices further down and causing further losses for the system.

Chart 4: Potential sales of ‘fallen angels’ relative to measures of market functioning

Sources: ICE BofAML, Morningstar, Solvency II, FCA and author calculations.

Although this is a useful exercise for assessing risks from potential large-scale downgrades to high-yield, it is reliant on a range of assumptions. In practise, the impact on market functioning could be larger or smaller than that estimated in this post for a number of reasons. For example, with respect to dealer behaviour, our liquidity metrics capture how dealers have actually been able to accommodate asset sales by clients over the past few relatively benign years, rather than on how dealers might be able to respond in a future stress event. In addition, investor behaviour could differ from that assumed here. Investors may choose to sell downgraded assets at a faster or slower pace to the one month used in this analysis. Furthermore, they may choose to sell only a portion of their exposure to ‘fallen angels’ rather than all of it. Alternatively, a wider pool of investors (eg pension funds or a broader set of investment funds) than considered here might sell a portion of their exposure to the downgraded debt.

In summary, our analysis suggests that the much larger volume of BBB-rated bonds in the sterling corporate bond market has materially increased potential financial stability risks associated with ‘fallen angels’. We find that were the downgrade rate of BBB-rated bonds to reach levels seen in 2002 and 2008, the associated sales by some investors could test the ability of dealers to absorb them, potentially causing market dysfunction, disorderly price moves and losses for investors in the high-yield segment of the corporate bond market.

Yuliya Baranova, Harry Goodacre and Jamie Semark work in the Bank’s Capital Markets Division.

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