The impact of the Covid-19 pandemic on companies and governments has put ratings under pressure around the globe. As the inevitable downgrades roll out, we look to our fundamental sovereign and corporate analysis to cut through the headlines and focus on what we can more reliably predict.
We prefer to look through the cycle to assess default risk, acknowledging that while winners and losers will emerge from the sharp, pandemic-driven economic contraction, the situation won’t last forever. However, we’ve observed during past market crises that rating agencies have tended to reflect nearer-term negativity in their actions and may be even quicker to downgrade emerging market (EM) issuers. Indeed, during the current crisis rating agencies have taken swift action across regional markets and across the rating spectrum – a trend that will likely elevate rates of “fallen angels” (entities downgraded from investment grade to “junk” or high yield) among EM corporate issuers.
While topline expectations for the rate of fallen angels among EM investment grade corporates may cause concern, a closer look at the factors contributing to those expectations reveals greater stability than may be perceived – along with potential opportunities that downgrades may present to EM investors. While downgrades are inevitable, we assessed the risk of the deterioration in credit ratings and found that the damage may not be as clear-cut (or as severe) as the headlines might suggest.
To date, nearly 250 EM corporate and quasi-sovereign issuers have been downgraded in 2020, compared with just 20 upgrades1. The sharp increase in downgrades follows a period of positive rating momentum, as net upgrades had been trending higher since 2015.
The downgrades include the nearly 8% of EM investment grade corporate and quasi-sovereign issuers that have been cut to high yield, with Mexico’s Pemex accounting for the lion’s share: nearly $60 billion in Pemex bonds, representing 6.6% of the EM investment grade market, have been lowered to speculative grade1. In addition, negative rating outlooks and near-term macroeconomic challenges factor into market expectations that the percentage of fallen angels among EM corporates in 2020 is likely to be materially higher (at around 14%) than for developed market (DM) corporates, potentially setting a new record if it surpasses the 2015 total of 13.6%. Importantly, rating agencies set ceilings on corporate ratings relative to their respective sovereigns. As in 2015, when sovereign downgrades of Brazil and Russia were outsize contributors to the record levels of fallen angels, sovereign risk is the main factor driving expectations in 2020.
When excluding issuers whose downgrade risk emanates from a negative sovereign outlook, fallen angels in EM are expected to range from 4% to 5% in 2020 on a standalone basis, not much higher than in the US (at 3.7%) or the EU (at 4.3%).1
Our analysis shows there are currently US $215 billion in BBB- rated securities outstanding, representing 21% of the investment grade EM corporate and quasi-sovereign market, with downgrade risk varying across and within regions.2
Latin America is expected to contribute roughly 75% of EM fallen angels in 20201, with the majority concentrated in two countries with negative sovereign rating outlooks: Mexico (dominated by Pemex) and Brazil. Within both countries, escalating risk at the sovereign level due to political turmoil and ambitious fiscal responses to Covid-19 will place a number of investment grade issuers under rating pressure.
While Asia accounts for nearly 50% of investment grade EM corporate and quasi-sovereign issuance, the majority is highly rated, at BBB or higher1. While a sovereign downgrade presents a potential risk of fallen angels among India’s corporate issuers, we expect India will maintain its investment grade ratings. As such, we believe fallen angel risk within Asia is low and issuer-specific, and that the region will contribute less than 2% to the overall full-year total.
Turning to EMEA, we don’t believe sovereign risk in the Middle East will factor much into fallen angel risk, as more than 90% of the region’s IG issuance is from countries rated A or higher1. We see just one fallen angel candidate in the Middle East, a state-owned port operator that underwent a leveraged recapitalization that continues to stretch its balance sheet. Europe is a much smaller component of the IG market, and although Russia – with low BBB ratings by Moody’s and S&P – could be a source of sovereign risk, we note that the sovereign is an upgrade candidate thanks to a robust policy framework and accumulated reserves.
At PineBridge, we maintain active coverage of more than 260 investment grade corporate and quasi-sovereign issuers3, each of which is assigned a fallen angel probability. While such forward-looking analysis is always important, it is even more essential in periods of short-term economic contraction like we’re seeing today, as the near-term negative rating trend increases the downside risks associated with a potential record level of fallen angels.
Our assessment of fallen angel risk relies on collaboration between sovereign and corporate research to gain a comprehensive understanding of which issuers might be downgraded. Our analysis suggests a fallen angel rate of just over 11% of the total EM corporate IG market, which is several percentage points lower than consensus estimates. Nearly 8%1 of the expected fallen angels have already occurred, paced by the record Pemex downgrade. This leaves just over 3.5%1 of the IG market likely to fall into high yield for the remainder of the year, which is not substantially higher than we might expect in a normal year.
Source: J.P. Morgan and PineBridge Investments as of 21 May 2020. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Forecasts are valid as of the date indicated and are subject to change.
The increase in BBB ratings within investment grade credit markets is often cited as a sign of an overall deterioration in credit fundamentals. To support outdated assumptions about underlying credit risk within the EM corporate market, skeptics may point to the higher concentration of BBB securities within EM corporate IG indices versus their developed market counterparts (at roughly 60% of the JPMorgan CEMBI Broad Diversified IG Index, compared with 47% of the Bloomberg Barclay US Corporate Bond Index). Notably, however, EM corporate indices do not include many highly rated issues from two key market segments of the investable universe: quasi-sovereign issuers, and many short-term securities issued by highly rated Asian financial companies (due to maturity constraints). When including these market segments, the concentration of BBB credit within EM essentially matches the 47% found within the US corporate market. More importantly, due in large part to the rating agencies’ sovereign rating caps, BBB credits in EM typically feature stronger balance sheets than their US peers. This is evident in EM BBB corporate net leverage ratios, which are a full turn lower than their US counterparts (at 2.0x versus 3.0x).4
Source: BAML and PineBridge Investments. Leverage as of 30 June 2019; spread as of 30 April 2020. For illustrative purposes only. We are not soliciting or recommending any action based on this material.
Just as quasi-sovereign issuers do not factor into corporate indices, they also are not captured in corporate balance sheet metrics. In the aftermath of Pemex’s record downgrade, and with many countries increasing fiscal programs to address the impact of Covid-19, scrutiny of quasi-sovereigns’ creditworthiness has increased. Quasi-sovereign issuers remain critical to their respective countries, and we would expect governments to provide increased support if fundamentals were to weaken. While fiscal deficits will increase this year, the ability of many sovereigns to issue debt at lower funding rates within their local markets should provide governments ample room to support their state-owned enterprises.
Fallen angels tend to be well-telegraphed, and market pricing typically follows a pattern of “sell the rumor, buy the fact” as rating-sensitive investors look to unload them before the downgrades actually occur. As a result, valuations tend to reflect a new rating paradigm before the downgrades take place, after which prices often rally as bonds find new sponsorship. The majority of EM corporate bonds are held either by local investors or dedicated EM investors, which are typically not rating-sensitive. As such, EM corporate bonds tend to be better insulated from some of the pre-downgrade selloffs that typically accompany fallen angels within DM credit markets. For EM investors who are not rating-sensitive, fallen angels with a high percentage of crossover ownership – meaning DM investors who typically are rating-sensitive – may present an opportunity to take advantage of attractive valuations that result from forced selling.
The repricing of EM corporate spreads during March reflected a level of risk aversion not seen since the global financial crisis. Although markets have stabilized and spreads have compressed since March, current pricing still reflects a more bearish outlook than we believe is warranted by market fundamentals. This is particularly true of the investment grade corporate market, where spreads per turn of net leverage are historically wide.
Given our expectation that fallen angel risk will be relatively well contained this year and driven primarily by sovereign risk (rather than systemic deterioration of credit metrics), we see an attractive opportunity to add exposure within the EM investment grade corporate market.
1 Source J.P. Morgan, S&P and Fitch as of 21 May 2020
2 Source: PineBridge as of 22 May 2020
3 As of 27 May 2020
4 J.P. Morgan as of 31 December 2019
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Last updated 1 April 2021