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Junk Bond Investors Eye 'Fallen Angels'

For many investors the possible downgrade of Spain’s debt to junk status by Moody’s next week is just another looming risk that threatens to disrupt the recent rally in risky assets.

Corporate Bond
Corporate Bond

But for those operating in the 250 billion euros ($323.4 billion) market of high-yield European debtit is being seen as an opportunity that could help propel them into a bigger league.

The thinking goes that if Spain, rated one notch above junkand on review for a downgrade, loses its investment grade status, it could end up dragging a number of the large corporates down the credit rating ladder with it.

The big rating agencies have made explicit the close link between sovereign and corporate ratings in recent months, with Moody’s talking about the “multiple channels of contagion” that exist between the two.

And if just a few big names were to become “fallen angels” and drop out of investment grade indices, it would be a huge addition to the still-developing European high-yield market, where participants have harbored hopes of it becoming as big as the $1.2 trillion junk bond market in the U.S..

Just Telefónica and Iberdrola dropping into the European high-yield arena would grow the market by nearly 30 percent at a stroke. If all the major corporates in Italy, Spain and Portugal, now teetering on the edge of investment grade, lost that status, it would help to more than double the market’s size to 500 billion euros over the coming years, say Credit Suisse analysts.

“The potential for the European high-yield marketto nearly double in size in part on the back of sovereign ratings downgrades is very exciting for us,” says Gina Germano, founding partner at Goldbridge Capital Partners. “Over time it would help the market on its way to being as large, deep and efficient as in the U.S..”

High-yield optimists suggest an influx of subinvestment grade companies could outpace what happened in the early 2000s when companies such as Vivendi , Rhodia and HeidelbergCement dropped below the investment grade level, injecting new money and liquidity into the high-yield market.

“Given the likely impact of European sovereign ratings downgrades on the corporate sector, we anticipate an unprecedented number of companies will become fallen angels, expanding the high yield sector substantially and creating fresh market opportunities,” says Mathew Cestar, head of European leveraged finance in Europe at Credit Suisse.

A Moody’s downgrade of Spainwill not necessarily lead to this, however. First, there is a loose rule set by the three rating agencies that corporates can be one or two notches above their country in certain circumstances, so the “junking” of Spain would not immediately make them subinvestment grade.

Second, companies would need to be “junked” by two rating agencies to fall out of the major investment grade indices and into the territory of high yield fund managers. Standard & Poor’s and Fitch both have Spain up for review, but have not been as tough as Moody’s in threatening to downgrade. S&P rates Spain three notches above junk and Fitch has it two levels above.

But this has not stopped investors making their preparations should Moody’s be the start of a trend. “We have already started to do credit work on some investment grade Spanish corporates ahead of possible ratings actions,” says Peter Higgins, co-manager of the global high yield funds at Bluebay Asset Management.

One question analysts are asking is whether large “fallen angels” entering the high-yield market would cause problems. “If the main issuers of peripheral corporate debt suddenly were to enter high yield territory, there may be a period where spreads widen as the bonds find new homes,” says Nancy Utterback, head of credit research co-ordination at Aviva Investors.

Valentijn van Nieuwenhuijzen, head of strategy at ING Investment Management, says: “There would be a medium term benefit in deepening the market, but in the short term it would cause a major disruption.”

There are already signs that the rally in high-yield debt since the end of July may be fading, in part because of the large amount of supply that has been issued. High-yield issuance has reached $10.3 billion already this month in Europe, which is the highest September on record, according to data from Dealogic.

The JPMorgan European high yield index for the best rated non-investment grade corporates has widened from an all-time low of 5.4 percent last week to 5.7 percent on Thursday. Bonds of high-yield companies such as Unitymedia, a German cable television group, and UPC, the European broadband internet provider, have lost value in the aftermarkets.

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