Back in November, still smarting from a year he would rather forget, Russell Clark and his Horseman Capital, i.e. the "world's most bearish hedge fund" unveiled what he would short next: according to Clark, the next major source of alpha would be shorting fallen angel bonds, or those investment grade companies in danger of being downgraded to junk.
Citing a recent IMF Global Financial Report, Clark said that "US investment grade debt is very low quality, and could produce some large fallen angels [and] mutual funds are much larger in the high yield market than they used to be. [L]ow rates means the capital losses are much higher than they used to be. And that investors in high yield mutual funds are much flightier than they used to be! Essentially the IMF are telling me that if you get a large enough fallen angel, the high yield market will freak out, and volatility will spike causing volatility targeting investors to dump leveraged positions. Sounds good to me."
One month later, in the aftermath of of Steinhoff fiasco, in which the ECB found itself long tens of millions of bonds in a company which went from investment grade to deep junk after it was revealed that it may have engaged in occasional fraud, crashing the bonds...
... Mario Draghi only made the bearish "fallen angel" case more explicit, by clarifying that going forward the ECB would likely liquidate bonds which were purchased as IG and subsequently downgraded to Junk (as we explained in detail in "The ECB Has Some Bad News For Junk Bond Buyers")
Then, at the start of June, legendary distressed investor Oaktree Capital, joined the bandwagon of fallen angel hunters, saying that the fund "expects to see a flood of troubled credits topping $1 trillion as rising interest rates overwhelm low-quality loans and bonds."
Speaking at the Bernstein Strategic Decisions Conference, Oaktree Capital's Chief Executive Jay Wintrob said that when the cycle turns it will be faster and larger than ever as "fallen angels" proliferate, and added ominously that "there will be a spark that lights that fire."
Picking up on last week's warnings by Moody's, in which the rating agency warned of a junk bond default avalanche as rates rise, Wintrob said that the supply of low-quality debt is significantly higher than prior periods, while the lack of covenant protections makes investing in shaky creditors riskier than ever.
According to the Oaktree CEO, those structural flaws of the bond market mean debt will fall into distress quickly once conditions flip, and "Oaktree is prepared with about $20 billion saved for future investing opportunities."
That number may be woefully insufficient: the total kept by S&P Global Ratings of potential “fallen angels”, or those investment grade companies in danger of being downgraded to junk, stood at just 45 in April, with $119.3 billion of debt outstanding according to Bloomberg. This is where Oaktree came in, with the rhetorical question posed by Wintrob to lenders, who "should be asking themselves if the market can continue to lend and extend maturities of debt at very low rates."
The potential opportunity for Oaktree is so pressing that the fund has now allocated about a quarter of its assets to troubled issuers.
To be sure, Horseman and Oaktree are not alone preparing for a surge in troubled issuers. The amount of “dry powder” held by fund managers to invest in low-quality debt has grown to around $150 billion, Wintrob estimated. Quoted by Bloomberg, he said this number has shown steady growth as the duration of bonds has increased, which could make the coming price drops even more significant than during the turn of the last credit cycle in 2008.
Which of course would be great news for America's bankruptcy advisors: as a reminder, a few months ago we quoted Moelis' co-head of restructuring Bill Derrough who said that "I do think we're all feeling like where we were back in 2007," adding that "there was sort of a smell in the air; there were some crazy deals getting done. You just knew it was a matter of time."
All that is needed is the spark.
* * *
And so, with everyone lying in wait for the proverbial "spark that lights the fire" and leads to the next inevitable bond crash, yesterday Moody's may have been playing with fire when the rating agency downgraded Ford Motor’s credit rating was to just one notch above junk, making it the biggest single "fallen angel" candidate in the US bond market.
Adding to Ford's recent woes after it embarked on a costly restructuring that could take years to complete, and rising costs as a result of Trump's auto tariffs, on Wednesday Moody’s downgraded Ford to Baa3 from Baa2 with a negative outlook, which means that just one more downgrade, and Ford will be rated junk.
The ratings company cited erosion in Ford’s "global business position and the challenges it will face implementing" its restructuring effort that could rack up $11 billion in the next three to five years.
Ford’s 5.291% notes due 2046 were among the biggest decliners in the investment grade market in the past two days, falling to the lowest since their 2016 issue, or just under 90 cents on the dollar...
... resulting in a generous yield of over 6%, nearly unheard of for an IG issuer these days.
As Bloomberg notes, a descent into junk would be a blow to Ford after six years of investment-grade status. Ford avoided joining its U.S. peers in bankruptcy during the financial crisis, largely thanks to more than $23 billion in loans taken out in 2006. Now, this massive debt pile is coming to haunt the company.
Moody's is just the first: last month, S&P cut Ford’s outlook to negative from stable and said prolonged weakness in profit and cash flow made a downgrade within two years increasingly likely. S&P rates Ford at BBB, two levels above speculative grade. But that will likely change soon, after the automaker lowered its profit forecast for the year, and is facing a number of headwinds beyond exiting the slowing sedan business in North America. The cost of complying with tougher emission rules in Europe and updating a stale product line in Asia contributed to second-quarter losses in those regions.
Earlier this year, Ford announced it would exit its storied U.S. sedan business, sending shock waves through the auto landscape. In addition, Ford and its Detroit counterparts have been in the crossfire of President Donald Trump’s trade talks with China and Mexico this year, causing volatility among U.S. automakers.
Commenting on the downgrade, Ford spokesman Brad Carroll said the company has had solid financial results and operating cash flows.
“The company has a strong balance sheet, which provides financial flexibility. We know we can capitalize on our strengths, bolster underperforming products and regions and disposition where we cannot make an appropriate return. We’re confident that as we do, the market will recognize our progress.”
Well, it had a strong balance sheet, not so sure about has, because adding to the income statement "perfect storm" is Ford’s rising debt/EBITDA, which has risen from 2.6x to 3.3x between 2016 and the twelve months ending June 2018.
It goes without saying, that slipping closer to junk status puts Ford at risk of higher borrowing costs, while an outright downgrade to junk would unleash a toxic spiral of surging interest rates at a time when Ford's profitability is sliding fast, forcing the company to issue even more debt to fund its operations, until one day creditors pull the plug.
But here is the bigger problem: Ford - which is now in danger of being a historic "fallen angel" - has more than $80 billion in debt, and would become one of the biggest issuers in the U.S. high-yield bond market if it gets downgraded even one more notch.
Of course, it may not be Ford that catalyzes the crash: as Oaktree warned there is now "a flood of troubled credits topping $1 trillion as rising interest rates overwhelm low-quality loans and bonds."
However, it would be poetic justice if the auto company that avoided bankruptcy during the Global Financial Crisis is the "spark" that - with its downgrade to junk - is the catalyst that unleashes the next bond market crash, as investors finally flee from the $1+ trillion US junk bond market, precipitating a cascade of selling that spreads into investment grade and, eventually, equities.
Which brings us back to the words from Moelis' co-head of restructuring Bill Derrough who in may said that "I do think we're all feeling like where we were back in 2007; there was sort of a smell in the air; there were some crazy deals getting done. You just knew it was a matter of time."
That time may be almost here.