Corporate debt is pricey now, but some 'rising star' bonds could pay off nicely for investors

Published Thu, Feb 4 20216:31 AM ESTUpdated Thu, Feb 4 202110:43 AM EST

Patti Domm @in/patti-domm-9224884/@pattidomm

The bonds of U.S. corporations are in high demand and therefore pricey in a yield-starved world, but there are some places investors can still look in the corporate bond market for potential reward. One place is the highest-quality rung of the junk bond market, the BB-rated companies that are no longer investment grade but want to be again. The economic shock of the pandemic and lingering impact on many industries pushed many companies from investment grade to junk in 2020. These companies are known as fallen angels. "The sweet spot in credit right now is actually BB," said Hans Mikkelsen, Bank of America's head of high-grade credit strategy. He said large capital structure issuers, rated BB, want to move back up to investment grade, and companies in that situation focus on improving their balance sheets and taking steps to make themselves more attractive. Some of those bonds downgraded during the pandemic are new to that tier, like Ford Motor , Delta Airlines or Occidental Petroleum. Kraft Heinz was also downgraded last year. These companies are considered "fallen angels." "We do think the trend will reverse, not that we're going to get fallen angels but rising stars should be a theme for the course of the year," said Jon Duensing, director of investment grade corporates at Amundi Pioneer. For the overall corporate market, Duensing expects spreads to continue to tighten but they are already at near-record levels. Since yields move opposite price, when corporate yields fall and get closer to Treasury yields, that is called tightening. "It's hard to imagine 2021 is going to look like 2020 as it relates to total return. The yield is 100-plus basis points lower than where market yields were at the beginning of 2020," said Duensing. "Spread levels are pretty comparable from where we were a year ago. Globally that has been the theme and has been for some time. There's lots of competition and demand from global investors that are looking for some kind of yield. That should keep yield levels low even around some concerns around inflation." Duensing said about $220 billion in investment grade corporate debt was downgraded to junk last year by rating agencies, as the economy crashed and some industries were hit hard by Covid restrictions. Bonds in the BB junk bond tier yield more than investment grade debt. For instance, the spread on BB-rated debt is 280 basis points, or 2.8 percentage points above Treasurys, Duensing noted. The average spread for the lowest rung of investment grade debt, the BBB-rated corporate bond is about 130 basis points. Investors in BB-rated bonds get a better yield but if the bond is upgraded, they could benefit from a higher price. "Rising stars tend to outperform until they get upgraded to the investment grade index," said Mikkelsen. After they are upgraded, "typically what happens is within a couple of months they will issue an investment grade bond, and that leads to further investment grade issues. That's when investment grade investors get comfortable." Columbia Threadneedle's Gene Tannuzzo, deputy global head of fixed income, cautions that it takes a while for companies to get upgraded. "The 'fallen angels becoming rising stars' story plays out much more slowly than what we saw in the downgrades," said Tannuzzo. "The downgrades happened in weeks. The upgrades happened in two years historically. It will take some time." Tannuzzo said the quality of the high-yield market has improved due to the fallen-angel bonds. "I think upgrades and credit improvement stories should be the focus," he said. Companies that had high leverage but are cleaning up their balance sheets and can use their strong cash flow to do so are candidates for upgrade, he said. Some energy companies could also be candidates for upgrade. "The lowest quality energy companies are gone and now have a lot investment grade fallen angels in the high-yield space," he said, noting they may do better once oil holds in the mid to upper $50s. "I think in energy we'd rather play upgrade candidates than lower-quality energy in high yield," he said.. Automakers are one of the industries that have seen their ratings move between investment grade and high yield the most, he said. Ford is the biggest issuer in the BB market, with a notional $44.5 billion in outstanding debt. "We've seen the automakers go between investment grade and high yield several times over the last couple of decades. We've also seen if they get their balance sheets under control, they could return to investment grade," he said. But strategists say if the economy improves and Covid retreats, there will be opportunities in a lot of industries. Other issuers in the BB tier include Netflix, Charter Communications, Lumen Technologies, Centene, T-Mobile , HCA and Apache . "Our base case expectations is we think through time with the broader vaccine rollout, herd immunity attained in the U.S. there should be a pretty decent growth impulse as many U.S. consumers look to spend more, especially on the service side," said Duensing, He said sectors tied to leisure and travel and dining should show improvement. "A lot of investors have the corona trade on," said Mikkelsen, commenting on some of the same sectors. "When you look at relative value in corporate bonds, there's still a little outperformance in these. It really started in November and the game changer is getting the vaccine." MGM and Hilton Worldwide have debt that is rated BB, as does Royal Caribbean Cruises . S & P Global Ratings said last week that fallen angel risk continues for corporate debt, but it's seeing signs of improvement. The rating agency said there were only two new fallen angels in December —automobile and aerospace company GKN Holdings and Innergex Renewable Energy. S & P characterizes fallen angels as issuers downgraded to speculative grade BB+ or below from investment grade, BBB- or above. Sectors like media and entertainment, transportation and aerospace and defense had a higher proportion of fallen angels to investment-grade issuers in December than at the peak of the financial crisis, according to S & P. "While potential fallen angels ended the year at 99 issuers — down from a historical high of 126 in April and May — potential fallen angels as a proportion of investment-grade issuers remained in the double digits for many sectors that could face weak revenue generation due to the COVID-19 pandemic or low energy demand," the ratings firm said.

New York Stock Exchange (NYSE) at Wall Street on January 12, 2021 in New York City.

Angela Weiss | AFP | Getty Images

The bonds of U.S. corporations are in high demand and therefore pricey in a yield-starved world, but there are some places investors can still look in the corporate bond market for potential reward.

One place is the highest-quality rung of the junk bond market, the BB-rated companies that are no longer investment grade but want to be again.

The economic shock of the pandemic and lingering impact on many industries pushed many companies from investment grade to junk in 2020. These companies are known as fallen angels.

"The sweet spot in credit right now is actually BB," said Hans Mikkelsen, Bank of America's head of high-grade credit strategy. He said large capital structure issuers, rated BB, want to move back up to investment grade, and companies in that situation focus on improving their balance sheets and taking steps to make themselves more attractive.