Lenders calm despite fallen angel risks

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White & Case LLPAlthough COVID-19 lockdowns have seen high-profile companies lose their investment grade status, lenders have continued to support these credits

COVID-19’s impact on earnings has seen companies across the United States and Europe lose their investment grade credit ratings and become so-called fallen angels.

According to Debtwire Par, between March (when lockdowns became prominent) and mid-August, there were 707 downgrades in North America, with the number of issuers downgraded coming in at 497. For Europe, the number of downgrades over this period was 380, with 248 issuers downgraded. Of those, 26 qualified as fallen angels in those regions during that same period, with 10 in North America and 16 in Europe.

In February, before economies shut down, the Organization for Economic Cooperation and Development warned that fallen angel debt could reach US$500 billion within a 12-month period. This risked a severe market dislocation as many investors are not allowed to hold bonds that are not investment grade and would have to exit any fallen angel credits.

This warning resonated during the first half of 2020, as household names in sectors directly impacted by lockdowns saw their bonds downgraded to non-investment grade status. These include Ford in the automotive space, Delta Air Lines and British Airways in the aviation sector and Macy’s and Marks & Spencer in retail.

Investors stay the course

While these downgrades have undoubtedly affected investors who had to sell down positions in newly sub-investment grade credits, the feared cliff edge that faced the market in March and April has been avoided.

In the US, the Federal Reserve, which normally only purchases investment grade bonds, has put temporary measures in place to relax these requirements and continued investing in fallen angels. The European Central Bank, meanwhile, softened its position and is no longer insisting that collateral assets for a bond must be investment grade quality. This support from central banks has helped to keep markets open for high yield issuance and avoid a fire sale of fallen angel credits.

Private and institutional investors have also adopted a pragmatic approach toward fallen angels coming to market or already in portfolios.

Investors avoided a kneejerk reaction to sudden ratings downgrades and focused instead on the opportunity: providing debt at attractive rates to companies that would be of investment grade quality in normal circumstances.

Private investors have also been sanguine about holding on to existing fallen angel credits. Although some institutions have firm red lines on non-investment grade bonds, many mutual and exchange traded funds can increase non-investment grade bond holdings within certain thresholds and have been able to digest higher numbers of fallen angel assets.

It is also important to remember that investors have experienced fluctuations between investment grade and non-investment grade pools over the past decade during the global financial crisis and European sovereign debt crisis. Through these periods of disruption, fallen angels continued to receive investor support.

The fact that fallen angels will also have reporting, documentation, disclosure standards and corporate governance infrastructure of investment grade quality should not be underestimated—investors like well-governed companies. This has seen fallen angel credits come to market expediently and tweak, rather than overhaul, existing capital structures.

Positioning and communication

Fallen angel borrowers, however, need to pay close attention to how any new borrowing is positioned to the market and their existing lender base.

Low interest rates, coupled with their innate investment grade qualities, have kept an array of financing options open to fallen angels, but these borrowers may still have to offer new debt on enhanced terms.

These could include better pricing, more collateral or additional covenants. Cruise operator Carnival, for example, was downgraded to a non-investment grade rating and subsequently raised a US$900 million bond at a 10 percent coupon, using its fleet as security for the finance.

For the most part, incumbent investors and lenders have been accepting and even expressly positive when well-run companies have raised additional finance on more lender-friendly terms to navigate COVID-19 disruption. But it is important for fallen angels to mitigate any conflicts with existing lenders and communicate openly about additional lending. Investors will take less kindly to COVID-19 support capital that is negotiated without disclosing terms to the existing lender base.

Taking on government-backed emergency loans requires an equally cautious approach. For some businesses, accepting state support can carry reputational risk. Borrowers may be able to use this as a bargaining tactic with their existing creditors for waivers or other looser terms in the current environment. There are also unanswered questions about how government loans will be refinanced when their terms expire in the coming months and years.

For now, the market may be said to be finding its own regimes for assessing credits in these unique circumstances, as ratings agencies appear to be sticking to their methodologies and resisting calls to suspend downgrades until the market is through the worst of the pandemic.

Fallen angels that clearly articulate their creditworthiness to investors, communicate openly about new financing and lever existing governance and reporting infrastructure, however, can continue to secure lender backing, even if they have lost investment grade status as a direct result of the pandemic.

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