The creation of fallen angels – and what rating agencies and QE have to do with it

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Riskier companies generally borrow at higher rates than safer companies because investors demand compensation for taking on more risk. However, since 2009, this relationship has been disrupted in the massive BBB corporate bond market, with risky BBB-rated companies borrowing from inferior rate than their safer BBB-rated peers. The resulting risk materialized in an unprecedented wave of “fallen angels” (or companies downgraded below the BBB rating threshold) at the onset of the COVID-19 pandemic. In this article, based on a related staff report, we argue that this anomaly was caused by a combination of factors: an increase in investor demand for higher quality bonds coupled with the quantitative easing (QE) of the Federal Reserve and a slow adjustment of credit ratings of risky BBB issuers.

The funding privilege of future fallen angels

The BBB segment of the corporate bond market has exploded since the global financial crisis, as shown in the chart below. The stock of BBB-rated corporate bonds has more than tripled since 2009 to account for more than half of all investment grade debt in 2020, up from 33% in 2008. BBB market growth has been particularly pronounced among issuers just above the BBB investment grade threshold, companies risk becoming fallen angels in the event of a downgrade. Notably, these future fallen angels experienced a substantial reduction in their bond funding costs even as their balance sheets grew more fragile.

The stock of outstanding bonds issued by BBB-rated companies tripled from 2009 to 2018

Sources: S&P Capital IQ; Thomson Reuters.

Note: This chart shows the evolution of outstanding corporate bonds, grouped by issuer rating category.

The chart below shows the bond spread between issuers vulnerable to downgrade and issuers not vulnerable to downgrade by rating (see the associated working paper for a formal definition of downgrade vulnerability). Would-be fallen angels paid 13 basis points less to borrow in the corporate bond market than safer BBB-rated issuers. If future Fallen Angels had been downgraded below BBB rating, their funding costs would have increased by about $300 billion over the 2009-2019 period, according to our calculations on the back of the envelope. This phenomenon is unique to BBB-rated issuers and particularly pronounced from 2013 to 2016, a period that coincides with a rapid, QE-induced expansion of the Federal Reserve’s balance sheet. We do not see a similar subsidy in the high yield corporate bond market (for corporate bonds rated below BBB), in equity markets or in the corporate loan market.

Future fallen angels pay Inferior Bond funding costs relative to safer BBB-rated issuers, which saved approximately $300 billion in bond funding costs from 2009 to 2019

Sources: merger; Thomson Reuters.

Note: This chart shows the spreads between downgrade-vulnerable and safer corporate bonds in each rating category from 2009 to 2019.

Outsized demand for bonds issued by future fallen angels is driven by QE and the role of credit ratings

The emergence of the future Fallen Angels grant amid the Fed’s high QE buying is no coincidence. Investors most exposed to QE (through their holdings of securities that were eventually purchased by the Federal Reserve) increased their demand for bonds issued by potential fallen angels, thereby reducing the costs of financing these companies. Investors who tend to hold higher quality bonds, such as insurance companies, experienced a more pronounced increase in QE-induced demand. Future fallen angels responded to this demand by issuing bonds, primarily to fund mergers and acquisitions (M&A).

Mergers and acquisitions activity was especially pronounced for would-be fallen angels and served two purposes. This allowed future Fallen Angels to delay downgrades and helped them grow their market share. These two forces have further increased the demand for bonds issued by future fallen angels. In our working paper, we document that as a result of M&A activity, there is a significant divergence between the “fundamental” rating and the actual rating, defined as the difference between the credit rating of a issuer as it appears from its balance sheet and its income statement (via the -called Z”-score) and its observed credit rating. M&A announcements are usually accompanied by optimistic forecasts of synergies and growth and, more importantly, a promise to reduce the debt incurred to finance the acquisition. The data indicate that most of these projections were not made ex post.

Future Fallen Angels Increase Market Share, Affecting Competing Firms

The growth induced by mergers and acquisitions in the market share of future fallen angels is considerable. The chart below shows that these companies roughly doubled their market share from 2013 to 2019, a momentum entirely driven by issuers engaged in M&A activity. This domination is done to the detriment of competing companies, which suffer from the presence of possible fallen angels on their markets. Growing market share for future fallen angels translates into lower employment, investment, sales growth, and product margins for competing companies.

Future Fallen Angels doubled their market share from 2013 to 2019

Sources: Compustat; Thomson Reuters.

Note: This graph shows the share of sales of all Compustat companies, grouped by rating and vulnerability to downgrade.

The Unprecedented Wave of Fallen Angels at the Start of the COVID-19 Pandemic

The early stages of the COVID-19 crisis revealed the vulnerability of future fallen angels. The volume of potential fallen angel debt that was downgraded in the first weeks of 2020 was five times greater than the volume of similar downgrades in the all Global financial crisis, as shown in the chart below. In our article, we show that these downgrades were driven almost entirely by potential fallen angels who had previously engaged in mergers and acquisitions. This unprecedented wave of fallen angels ended after the Federal Reserve announced on April 9, 2020 that facilities put in place by the Federal Reserve and designed to purchase corporate bonds would include issuers downgraded from BBB between the March 22, 2020 and April 9, 2020.

Downgrades in 2020: Q1 was five times larger than Q1 All The global financial crisis

Sources: Compustat; Thomson Reuters.

Note: This graph shows the debt of future fallen angels downgraded, at an annual frequency from 2007 to 2020.

Lessons for the future

In many ways, the growth of higher quality risky corporate bonds may be a desired outcome of monetary policy, as investors demand riskier assets in response to QE. Our results suggest that market frictions, such as reliance on credit ratings and the desire for higher returns by quality investors, interact with stimulus policies, contributing to capital misallocation and the accumulation of vulnerabilities in the corporate sector. These important side effects may need to be considered when considering the design of EQ programs in the future.

Viral V. Acharya is a professor of finance at New York University’s Stern School of Business.

Ryan Banerjee is a senior economist at the Bank for International Settlements.

Matteo Crosignani is a Senior Economist in the Research and Statistics Group at the Federal Reserve Bank of New York.

Tim Eisert is Associate Professor of Finance at Erasmus University.

Renée Spigt holds a doctorate. candidate for Erasmus University.


Warning
The opinions expressed in this article are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

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