Ford, Fallen Angels, & Opportunities
Ford Motor was recently downgraded to Baa3 and placed on negative watch by Moody’s. Why is this significant? Well, at Ballast, we acquire assets in portfolios and believe we are capturing more return for the fundamental risk than we are taking. Ford’s downgrade and this article address an area where we like to troll for opportunities – which are Fallen Angels.
Fallen Angels are companies whose credit rating has fallen from Investment Grade (IG) to High Yield (HY), and they are an area where market pricing sometimes reflects technical currents rather than economic fundamentals. Even the Fed seems to agree – so let’s examine why.
The universe of IG is much larger then the universe of HY, both from a supply and a demand side. On the supply side, the Bloomberg IG index is just over $5 trillion in size, while the Bloomberg HY index is $1.27 trillion. On demand side, there are many more dollars allocated to IG than to HY. A quick example of this is an insurance company. An average insurance company may have 50-55% of their total general account allocated to IG issuers, while their allocation to HY may be mid-single digits. So, an insurance company (just like pensions, banks and other regulated institutions) has capital allocated to IG that is a multiple of what it allocates to HY.
Why does this matter?
Well, if a company is a large borrower – like in the case of Ford (which has about $35 billion in the IG index) – then it is heavily dependent on the debt markets for financing needs. Whether those needs be for operations, capex, or debt rollover, they are met by market participants (insurance, pensions, banks) that have lots of capital ready to be deployed. However, when a credit deteriorates and moves to HY from IG, then things get interesting.
Typically, large institutions (banks, insurance, pensions) have policies and/or risk-based capital charges that either restrict their ability OR make it very costly for them to invest in non-IG bonds. Therefore, when an issuer no longer meets IG ratings, then that market participant no longer purchases that debt and, more likely, begins to sell the debt it already owns. This selling pressure (from pure policy/regulated reasons) provides opportunities.
Simply put, when you have a lot of paper moving from a large pool into a small pool, it takes time and adjusted prices for you to reach equilibrium. It is during this time that credit-minded investors can assess and source paper that provides attractive opportunities.
Note: Some fallen angels that we currently own are Diamond Offshore and TEVA Pharmaceuticals.
It remains to be seen whether down the road Ford bonds will present an opportunity or not. However, rest assured we are following this – and other potential Fallen Angels – for opportunities to acquire assets at prices that don’t reflect their intrinsic value.