‘Fallen angels’ are posing the biggest threat to the bond market this year

The riskiest part of the corporate bond market is off to a strong start in 2019. Investors, however, might not want to get too comfortable.

Instead, this could well be the year that “fallen angels,” or former investment-grade debt that gets downgraded to speculative, shapes up as one of the more compelling fixed income stories and poses the greatest risk to a sector that has attracted considerable levels of investor cash.

Coming off a brutal 2018, high-yield bonds — junk, in the market vernacular — have started the new year with a bang. A popular play in the sector, the $14.8 billion iShares iBoxx $ High Yield Corporate Bond exchange-traded fund, has been one of the leaders in attracting investor cash, pulling in $1.18 billion in inflows this year.

This year’s rebound comes off a December when the high-yield market dried up. Low-rated companies stopped issuing debt amid a freeze in market activity and a big drop in the stock market that reflected a general risk-off attitude.

Bond market pros are warning, though, that the more constructive atmosphere looks to be temporary and that worries over corporate debt will last through the year.

“History indicates that high yield typically bounces back from negative return years, so we can understand why many strategists are increasing their 2019 forecasts,” Michael Anderson, head of U.S. credit strategies at Citigroup, said in a research note for clients. “In our view, December’s swoon is indicative of an increasingly fragile market. For most of 2018, investors wondered what could derail high yield. Now we see how quickly things can turn.”

Anderson forecasts a middling year for the sector, with expected returns of 2.9 percent.

However, he notes that the possibilities run to the extremes. History since 1990 suggests that when high yield has a bad year, the next year sees a sharp rebound, with an average return of a whopping 29.16 percent.

“The most likely outcome for high yield in 2019 is either a big rebound (with returns in the low teens) or further weakness and another negative year (or close to a negative year),” he wrote.

One of the big wild cards for the sector is companies that suddenly go from investment grade to junk or worse. The market just lived through a big one — Pacific Gas and Electric, which could become the third-largest investment-grade bond default behind only such infamous luminaries as Lehman Brothers and WorldCom.

If it does default, PCG would become part of an even smaller group that also includes Enron, MF Global and Lehman that went straight from investment grade to default without first landing on the fallen angels list.

On a broader level, the situation is part of a nightmare scenario in which a large swath of investment-grade companies slide into junk status and create a liquidity glut. The high-yield market is shrinking, at a five-year low of $1.25 trillion ending 2018, and a lack of buyers would send yields surging and could capsize companies with weak balance sheets.

At this point, most of Wall Street thinks the issues will be company specific and not likely to pose systemic risk.

But investors have heard that before.

“Investor concerns over global IG downgrades to HY status have escalated significantly. This fear is not without justification,” UBS strategist Stephen Caprio said in a note. “The threat of IG downgrades could induce forced selling and lead to higher financing costs for large indebted companies, while increased HY supply could widen spreads.”

However, Caprio said current conditions indicate that a cascade of junk debt problems is unlikely.

In the most likely scenario from UBS, a total of $40 billion worth of debt could be downgraded, centered in telecom, energy and consumer noncyclicals. That would only be a small part of the market, though Caprio notes that there’s a bigger risk in Europe.

Should a recession hit, he forecasts that downgrade volume could hit $218 billion, which would be about 18 percent of the total market.

“While disruptive, this would be lower than the $360bn & $310bn in ’05 & ’09,” he wrote.

Ultimately, Caprio warns against betting against the BBB-rated space as “likely premature” though he thinks investment-grade bonds are a better move.

Indeed, investors have been flocking to higher-quality bonds on the near end of the duration curve. Two popular Vanguard ETFs, the Short-Term Corporate Bond and the Intermediate-Term Corporate, have pulled in nearly $5 billion in new cash this year despite comparatively lackluster returns of not much more than 1 percent.

There’s a lot at stake in that area as well — Moody’s estimates that some $1.04 trillion in speculative-grade five-year debt is maturing through 2023 along with another $1.05 trillion in investment-grade bonds. The ratings service said that media and technology represent the biggest part of the maturing debt.

Fixed income in general has been a big preference for investors during the stock market volatility that began in the fourth quarter. Market data firm TrimTabs said the previous three months have seen the biggest cash surge to bonds in all the years its been tracking fund flows.