Managers preparing for major bond bonanza

Investment-grade bond managers are labeling 2021 and 2022 as the years of the upgrade, with a bonanza of high-yield companies set to climb up the credit scale.

In anticipation of ratings agencies upgrading up to $100 billion in high-yield companies' bonds to investment-grade status this year, with a further up to $200 billion earmarked for upgrades in 2022, investment-grade managers — where strategies allow — are adding junk bonds that they expect to be upgraded in hopes they will reap the benefits.

"2021 will be the year of the upgrade," said Matt Brill, Atlanta-based head of North America investment-grade and senior portfolio manager at Invesco Ltd.'s fixed-income business. "The main takeaway is that the momentum is positive for corporate deleveraging. ... That's gone through the pendulum swing very far down to the downgrade side (when) institutions were deteriorating in terms of credit quality last year," and now the opposite is true, he said. The firm had $296.4 billion in fixed-income assets under management as of Dec. 31.

Vontobel Asset Management AG's fixed-income team expects $200 billion to $300 billion of U.S.-based high-yield debt to be upgraded to investment-grade status by the end of next year, with about €50 billion ($59.6 billion) for Europe over the same period.

A Dec. 2 paper by S&P Global Ratings said an estimated $367.2 billion in outstanding debt had been downgraded from investment-grade status so far in 2020. The paper covered the U.S. and Europe, Middle East and Africa.

"It's tough to get a precise answer (of how much will be upgraded) but the topic is gaining traction because we entered a new period in the credit cycle with COVID-19," said Christian Hantel, Zurich-based senior portfolio manager.

"It was a disaster last year because EBITDA was falling off a cliff ... credit numbers deteriorated sharply," and the result was some companies were downgraded, he said.

But as the global economy is moving into the recovery period, it is "all about healing and repairing balance sheets and restoring credit metrics," with signs already pointing in that direction, Mr. Hantel said, citing fourth-quarter earnings coming in "quite solidly across the globe." Vontobel ran 48 billion Swiss francs ($54.4 billion) in fixed-income assets under management as of Dec. 31, according to its 2020 annual results.

Companies such as Kraft Heinz Co. are credits in which investors are taking positions in anticipation of upgrades this year or next, sources said.

And though there are no specific sectors from which managers expect upgrades to originate, Mr. Brill described three "buckets" of companies that are on the potential upgrade list: fallen angels, which were downgraded to junk status in 2020 but are expected to return this year or next; companies that have languished in the high-yield category for years, such as some of the homebuilders downgraded in the aftermath of the global financial crisis that have benefited from delevering and a better housing market; and newer companies such as technology firms that have not yet built up mature credit structures to be admitted to investment-grade.

In that final set of firms, managers named companies such as Netflix Inc. among candidates for an upgrade.

The accommodative actions provided by central banks in 2020 as part of an effort to reduce the impact of the pandemic has helped drive down the default risk, forming strong demand for high-yield bonds. Because of that, managers said they are interested in adding both fallen angels and high-yield bonds that were never in the investment-grade category because the spread between the highest-rated junk bonds that are BB-rated and investment-grade bonds that are at least BBB-rated, has been quite attractive.

"(We) can be picking up bonds that have never been investment-grade that (are) probably going to be upgraded. ... We are trying to be ahead of the rating agencies' decisions (in) both directions by looking at company cash flow and debt levels," said Sabrina Jacobs, fixed-income investment specialist at Insight Investment Management Ltd. She said about $1 billion of newly upgraded bonds became available to investment-grade managers in January alone. Insight had £753 billion ($1.02 trillion) in assets under management as of Dec. 31.

But just looking like they might be upgraded will not automatically get high-yield companies into investment-grade portfolios. "We're not looking for muddling-along high-yield names that are BB and we think will stay that for a long time, but for specific upgrade candidates," Invesco's Mr. Brill said. "I would point out that a lot of these deals are fairly liquid, too — you can find these bonds. They're generally not things that are just needle in a haystack, (but) relatively large, liquid deals."

But managers waiting to capture recent fallen angels may need to be patient. "We are not going to see the same velocity on the way up," said Henrietta Pacquement, senior portfolio manager and head of investment-grade for the European credit team at Wells Fargo Asset Management in London. She said the firm is considering adding high-yield bonds that could be upgraded to investment-grade later this year as the firm has the flexibility to hold them. "Sectors that are more of interest, for example, are cyclicals that have gone down and we might be expecting them to get back to investment-grade," she said.

Some managers have increased flexibility to hold high-yield bonds. Ms. Jacobs said Insight increased the allowance to hold high-yield bonds on a portfolio level by about 1% or 2% due to spreads on relative basis.

Adding companies that are expected to be upgraded is a good source of alpha — so long as you buy the bond early enough in the process, said Andreas Michalitsianos, portfolio manager with the global investment-grade corporate credit team at J.P. Morgan Asset Management in London. "It was a trade you needed to position early for to extract the most value and we feel we did that," he said.

But that opportunity is getting smaller as upgrades are now imminent. "If I look at a BB and BBB- (bond), they are not a million miles away (in terms of spread). We are talking 25 basis points," he said.

Some of the manufacturing companies and stressed credits that were downgraded from investment-grade status in 2020 due to the COVID-19 crisis may offer investors a significant return opportunity to capture the spread tightening that occurs as a result of the re-rating back to investment-grade status, said Brian Kloss, portfolio manager on the global fixed-income team at Brandywine Global Investment Management LLC, an affiliate of Franklin Templeton in Philadelphia.

Mr. Kloss noted that due to the interest rate risk that is evident through increasing yields in the Treasury market, his firm is reducing exposure to long-dated investment-grade corporate bonds to 5% to 10% from a high of 25% to 30%, and replacing it with both shorter-dated investment-grade corporate bonds and high-yield corporate credit.

"We started to move out of longer-dated investment-grade corporate credit exposure as spreads retraced the pandemic widening, leaving very little cushion to absorb an increase in interest rates," he said.

And managers continue to add potential rising stars. Last month Jon Mawby, head of investment-grade credit at Pictet Asset Management in London, said for its unconstrained strategies, the firm launched a strategic trade to short some of the overlevered cyclical sectors/companies rated BBB and to go long on BB-rated bonds expected to be rising stars. "We feel (the) outlook and ratings pressure will continue to build as rating agencies don't want to be seen (to be) behind the curve as they did in the last financial crisis."

Other managers are also increasing their high-yield exposures at the expense of long-dated corporate bonds.

For example, Stephan Ertz, head of credits at Union Investment Holding AG in Frankfurt, also added a mix of high-yield bonds into investment-grade portfolios reaching the maximum 10% bucket about two weeks ago, from 5% in November. The firm sold long-dated investment-grade corporate bonds.

"Balance sheets of companies are improving ... it is enough to stabilize your credit metrics, we expect growth, that should help high-yield companies. You should then already buy them; not wait until there is a possibility (that) there will be an upgrade," he said.

Mr. Ertz said he preferred a high-yield position over investment-grade currently. "It is a better place to have low duration, high-spread high-yield bonds than high-duration, low-spread investment-grade bonds."