Let's Unpack the Recent Downgrades to Junk

Kraft Heinz , Macy's and Renault have recently been downgraded. So, they should transition from investment-grade bond indexes to high yield bond indexes, right? And, is this the start of a slew of rating agency downgrades and will it impact overall credit spreads dramatically? Probably not -- and not for now -- are my answers. I get into those two point in depth, but first, let me repeat that I do not recommend owning individual bonds. In credit, especially for high yield and leveraged loans, I continue to recommend active managers, even exchange-traded funds, as active managers can consistently outperform index-based investing in credit. This is partly because of how the new issue market works and partly in the faulty nature of credit indexes -- bigger issuers count for more. Now, let's look at the two questions important for all your bond market investments: First, is this the start of a wave of downgrades? And, second, can the high-yield market absorb the downgrades? To answer the first question, no, this is probably not the start of a wave of downgrades. Each company has its unique reasons for being downgraded. Still, after years of watching the rating agencies, I have to add some caution. It seems like we need to be prepared for a slow growth scenario and we don't want to be caught with too many credits on the cusp of being investment grade or high yield before that occurs. If this is true, we should see some single B credits downgraded to CCC, especially in the leveraged loan space. (Remember BB, B, and CCC are typically considered junk bonds.) That will put pressure on leveraged loans and ETFs like Invesco Senior Loan ETF , and SPDR Blackstone / GSO Senior Loan ETF would likely sell down a bit like it did late last year when those firms were first floated around the market. That will be a buying opportunity in leveraged loans, just like it was in early December. As for the second question, about absorbing the downgrade, that isn't quite the right question. The right question is how much forced selling there will be. Before we answer that question, let's state one very important fact: These companies traded at the wide end of investment grade and in some cases, were already barely trading tighter than the average BB credit. Basically the market was already pricing this risk in. Chart Copyright 2020 Bloomberg Financial. In terms of forced selling, I will break the universe into active vs. passive managers and those that have the flexibility to own BB credits and those that don't: Passive, but Flexible. I would expect most investors who meet this definition have done it precisely, so they can avoid being forced sellers. The fear mongers won't explain to you that many insurance companies and pension funds are no longer forced sellers. Active and Flexible. Since the issues facing these companies were well known, I'd be shocked if an active manager with flexibility to hold high yield paper would be a seller here. In fact, it would go against everything I think a good credit manager would do -- you either liked this paper and would add more or you shouldn't have owned it (my strong opinion). Active with rules. This category should encompass primarily mutual funds. Many were already underweight this name, which should limit the forced selling. Passive with Rules. Will have to sell. This is the forced seller. Having said that, I pulled up iShares IBoxx Investment Grade Corporate Bond Fund ETF with a market cap of $35.8 billion. As of its last filing, it had $0.2 billion of KHC debt. So about 0.6% of its assets under management will need to be sold by LQD (other funds like it should have a similar percentage of assets to sell). This is real selling. The Players: The High Yield Market As for my current image of the high yield market, its Pac-Man. I now have that gobble gobble sound from Pac-Man playing over and over in my head, but I think the high yield market, which has been looking for high quality BB paper, will have little problem digesting these bonds. As far as I can tell, people are foaming at the mouth to buy the new Sprint -T-Mobile deal. Finally, for the high yield passive forced buyers, there are funds that will have to buy these bonds because while LQD will have to sell, the BlackRock HY ETF will have to buy. Bottom Line Expect the transitions to go relatively smoothly. I am still nervous about risk due to coronavirus, but I wouldn't shift my fixed income holdings just because of these downgrades and if credit spreads widen significantly, I'd want to add risk.

Let's Unpack the Recent Downgrades to Junk

Kraft Heinz, Macy's and Renault have all recently been downgraded, and now the question must be asked: Is this the start of something bigger?

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