Written by: Fran Rodilosso
The cautionary advice to “expect the unexpected” makes a lot of sense for investors—at least in the sense that we should all learn to manage our own expectations by realizing there are outcomes we may not have anticipated. Sudden defaults by investment grade rated issuers would fall into this category, given their rare occurrence.
At VanEck we are anticipating a pick up in the volume of fallen angels, or investment grade bonds being downgraded to high yield status, in 2019. Our theory is not that we will see a systematic turn in the credit cycle that causes a massive wave of BBB-rated debt to fall into the high yield universe, but that we will see a variety of idiosyncratic situations develop.
From Fallen to “Failing”
One such situation occurred this month as a direct result of the very tragic wildfires that struck California over the last two years. Pacific Gas and Electric (PG&E), with nearly $18 billion in bonds1 in the ICE BofAML US Investment Grade Bond Index, is facing upwards of $30 billion in legal claims, which would render the utility insolvent. A series of downgrades by multiple agencies have brought the issuer’s rating quickly down from a BBB- to C during just the first two weeks of January.2 The bonds are effectively fallen angels, or as ICE BofAML more aptly labeled them in a recent note, “failing angels.” On January 14 the company announced that it would seek Chapter 11 protection as soon as January 29. On January 15, the company declined to make an interest payment due on one of its senior unsecured bond issues. PG&E’s debt prices have fallen significantly.
PG&E’s Bond Prices Have Plummeted
PCG 6.05 3/1/2034
1/1/2018 through 1/16/2019
Also on January 15, ICE BofAML announced that, although the bankruptcy filing date would fall after the preview date for its high yield indexes, PG&E’s bonds would NOT be added to the ICE BofAML high yield indexes, including the US High Yield Index or the US Fallen Angel High Yield Index. The indexer made this decision based on the very high likelihood that these bonds would no longer qualify for inclusion by the next index rebalancing at the end of February, because defaulted bonds are excluded from their high yield bond indices. It is somewhat unusual for an investment grade company to default without first entering the high yield market, and PG&E would join the ranks of companies like MF Global, Lehman Brothers, and Enron.
A Thoughtful Exclusion
We believe the indexer has exercised discretion with regard to the index rules in a thoughtful and prudent manner. That is not to say the bonds in question are certain to fall further in value, that PG&E investors have been saved from losses, or that the bonds cannot rally from here. Markets are quick to price in bad news, and the reorganization of PG&E could, under reasonable assumptions, leave a high recovery value for the bonds. It is also possible that the situation could change, and that PG&E does not ultimately file for bankruptcy, in which case the bonds could still enter the high yield indices on the next rebalancing date at the end of February.
From our perspective, the worst case scenario would be the inclusion of a large index component that would have to be sold in one month, causing the incurrence of potentially high transaction costs. However, as has been the case historically with fallen angels, we could also have been buying debt that had already fallen precipitously and priced in significant likelihood of default, only to subsequently rebound in value. For example, just three years ago a wave of energy names entered the index following the collapse in oil prices, which contributed to strong performance in following years. This is, in essence, the VanEck Vectors Fallen Angel High Yield Bond ETF’s underlying strategy and a distinct value proposition of fallen angel investing, which has provided long-term outperformance versus the broader high yield market historically.3
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