In our June Credit Check-In, we noted how higher oil prices and fallen angels have driven dramatic spread compression across the high yield (HY) energy sector. These same forces, combined with recovering fundamentals – that never were as weak as expected – and large-scale economic reopening, are contributing to a broader shift in investors’ focus from fallen angels to rising stars.
Danger of downgrades fades
A year ago, with the pandemic in full swing across the US, our investment grade (IG) downgrade watchlist (which includes credits with more than a 30% chance of being downgraded to high yield) had a market value of $434 billion – equivalent to 18% of the Global High Yield Index – largely from auto, energy and travel-related companies, such as hotels and airports.
But the drawdown in revenue in 2020 was not as bad as many investors and rating agencies feared, oil prices have soared from around $40 per barrel a year ago to over $70 currently and economies have largely reopened, including for travel and leisure activities. As a result, fundamentals for companies in these sectors have significantly improved and analysts are increasingly comfortable with the ability of these companies to keep their investment grade ratings.
That’s lead to a sharp decline in the market value of credits on our watchlist as well as a big change in its composition. As of July, our IG team’s watchlist had a market value of just $95 billion, or 3% of the Global High Yield Index, and largely concentrated in real estate investment trusts (REITs) and consumer cyclical companies, particularly auto-related and smaller European names. Due to their long-term leases, REITs are experiencing a somewhat lagged effect from the pandemic, which is weighing on current fundamentals and ratings in some sub-sectors, such as retail and healthcare, and landing a higher number of REIT names on the watchlist.
Source: Goldman Sachs Asset Management. As of July 28, 2021. Our watchlist includes bonds from issuers with a more than a 30% chance of being downgraded from investment grade to high yield.
Focus shifts from fallen angels to rising stars
Fallen angels accounted for more than $200 billion of debt migrating to the HY index in 2020 and pushed the BB segment to an all-time high of 55% of the total HY Index, well above the historical average of 46% over the last decade.
A year later, watchlists reflect the potential for fewer fallen angels. Instead, rising commodity prices and strong earnings outlooks – supported by economic reopenings and management focus on deleveraging balance sheets – are driving the potential for rising stars.
Already, merger and acquisition activity in the energy sector, combined with strength in the housing sector, lifted six rising star candidates to IG status. These defections from HY were offset by continued strength in BB-rated new issuance, and the net effect has been a slight reduction in the BB segment of the HY Index to 54% of the market by mid-2021. Our HY investment team has identified more than $215 billion in rising star debt that it expects to be upgraded to IG over the next two years, largely across the energy, technology, consumer cyclical and electric utilities sectors. We also believe two additional large capital structures comprising more than $60 billion in debt could achieve IG ratings by the end of 2023, boosting the market value of the adjusted rising stars list to almost $300 billion, or 20% of the existing HY market.
“The bigger focus right now is the potential impact from rising stars."
— Goldman Sachs Asset Management Fixed Income Portfolio Manager
Goldman Sachs Asset Management Forum | June 2021