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Who’s to Blame for Fallen Angels and Sinking Demons?

Shuli Ren

(Bloomberg Opinion) -- The coronavirus age demands action. So the Big Three credit ratings agencies are downgrading borrowers with a hammer, moving at the fastest pace on record. Some market observers are already pointing fingers, saying ratings were too high to begin with. But who’s really to blame for all this?

Investors don’t like abrupt, large-scale downgrades. Slashing companies’ ratings from investment grade to junk — so-called fallen angels — or to more distressed levels, will spark massive selling pressure in the money management world. Bond funds often have mandates dictating whether and how much they can invest in high-yield issues.

Already, Western Asset Management Co., one of the biggest U.S. bond managers, has asked for a waiver from a California public pension fund seeking extra time to get its books in order after two major downgrades pushed the fund over its limit for junk-rated holdings. In the first quarter, fallen angels’ debt outstanding came to about $150 billion, exceeding the peak reached after the collapse of Lehman Brothers Holdings Inc.

Ratings for leveraged loans could also turn into a big headache. Most managers of collateralized loan obligations, which package these loans and sell them in tranches, are mandated to limit the weighting of CCC rated issues to 7.5%. No one wants a fire sale.

More pain is in store. Over the next six months, another $555 billion worth of angels' debt outstanding might fall, amounting to about 15.7% of the BBB bucket, estimates Goldman Sachs Group Inc. That’s in part because agencies have been slashing their company outlooks. Roughly half of investment-grade bonds are in this rating category.

If you’re worried about fallen angels, consider what I’ll call sinking demons, issues that get downgraded from the lowest B notch to CCC. There are plenty of them in the $1.5 trillion leveraged loan market: About 30% of such loans rated by Moody’s Investors Service Inc. are in the B category, versus 12% in 2008. Sinking demons could push the percentage of CCC issuers beyond the 16% peak recorded in 2009, Moody’s warned.

Granted, agencies have a moral hazard: They get paid by the issuers they rate. But are they really responsible for so many fallen angels and sinking demons? As I noted last week, the leveraged loan space has ballooned over the past decade, largely because the savvy private equity industry has been stuffing this market with low-quality, covenant-lite issues just a notch shy of CCC.

The Federal Reserve is clearly worried. On March 23, it established a facility to buy corporate bonds issued by investment-grade U.S. companies, though it’s still loath to make direct loans to ones in distress. Since the passage of the Dodd-Frank Act in 2010, the central bank hasn’t been allowed to take big credit risks and can only lend with a high degree of protection, either buying assets super cheap or being backed by the Treasury’s money. So passing down lower borrowing costs through the pipeline of investment-grade corporate bonds might seem like a good idea.

But is it? By subsidizing the most solvent lenders in the system, the Fed is once again artificially pushing down yields and forcing investors further along the risk curve. In fact, one may argue that the Fed — more than ratings agencies — is the reason so many investment-grade bonds are now clustering at the category’s very low end.

Now that Fed Chairman Jerome Powell seems to have put out the wildfire, we are starting to see inexplicable risk-taking behavior again. Last week, Carnival Corp.’s $4 billion new bonds were gobbled up, even though it operates the Diamond Princess cruise that had more than 700 infected coronavirus patients.

It’s easy to point fingers at ratings agencies. But in reality, they don't move the pricing needle unless they downgrade by more than one notch, or pencil in a fallen angel or sinking demon. What matters is the Fed.

Now if this were China, the government would start giving “window guidance” and telling ratings agencies to stop publishing these aggressive downgrades. Thankfully, the Fed isn’t Big Brother. But keeping would-be angels on life support will bedevil any much-needed reckoning in the credit market.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. She previously wrote on markets for Barron's, following a career as an investment banker, and is a CFA charterholder.

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