STA Weekly Report – Bonds: Do We Expect a Massive Wave of “Fallen Angels”?
Written by Luke Patterson | Tuesday, June 4th, 2019
INSIDE THIS EDITION: Bonds: Do We Expect a Massive Wave of “Fallen Angels”? 1033 Exchanges: Tax Relief for Involuntary Conversions due to Fire, Theft, Natural Disaster, Eminent Domain, Seizure and Condemnation 401k Plan Manager
In fixed income, a fallen angel is an investment bond (rated BBB- or higher) that is downgraded to a junk rating (BB+ or below) by Moody’s Investors Services, S&P Global Ratings or Fitch Ratings.
As the lowest rated bonds in the investment grade universe,
BBB bonds have the highest probability to be downgraded into the junk rating,
also known as high-yield. A slowdown in growth, especially a prolonged
recession, can significantly magnify the magnitude of the downgrade.
What concerns investors is that the total market value of
BBB bonds has skyrocketed to more than 2 trillion dollars from merely 0.8 trillion
dollars a decade ago. Furthermore, BBB-rated bonds now account for half of the
investment-grade corporate bonds, up from 35% 10 years ago.
Ultra-loose monetary policy by global central banks lowered
borrowing costs significantly over the last decade, which allowed companies to
borrow cheaply to issue dividends, buy back stocks, and pursue aggressive
growth strategies, such as mergers and acquisitions.
On the other hand, an aging population, looking for
alternative income sources in a low interest rate environment, has created
strong demand for high yielding assets and has helped absorb the increased
supply of lower rated bonds.
Historically, BBB bonds have only presented a moderate risk
of default. According to S&P Global rating, the cumulative default rates of
BBB bonds between 1981 and 2018 have been in the low-to-mid single digit range.
In comparison, more than 20 percent of BB bonds, the highest rated junk bonds,
have experienced default for a 10-year holding period on average.
Why should investors care if BBB bonds only have moderate default risk as a group? An increasing number of BBB bonds carry greater leverage than BB bonds. Most issuers in this category used debt to finance mergers and acquisitions. Because rating agencies believed that stable cash flows generated from the combined companies would be able to deleverage the balance sheet over time, they left credit ratings unchanged despite deteriorating credit fundamentals. During a recession, however, companies that have promised to lower their leverage may not be able to do so, which may eventually trigger a rating downgrade.
Once an investment grade bond becomes a fallen angel, its junk
status can force a wave of selling by investment companies and funds whose
mandates prevent them from holding credit below investment grade. This can
create liquidity issues if the junk bond market doesn’t have enough capacity to
absorb a large quantity of supply in a short period of time. Evaporating dealer
inventory, as a result of tighter regulations after the financial crisis, only
exacerbates the situation.
Despite the hidden risks, the valuations of corporate bonds
remain rich. The option-adjusted credit spreads of both investment grade and
high yield bonds are near historic lows, after slightly widening during the
recent market selloff. While tight credit spreads reflect current low levels of
corporate default, it may not fully compensate investors for potential credit
and liquidity risks, in our view. As a result, we urge caution against chasing
S&P 500 Trades Back Over its 200-Day Average
A combination of a short-term oversold condition and dovish sounding comments from the head of the Fed are giving a big lift to stocks today.
All major indexes are showing strong gains with the Nasdaq in the lead (+2.1%). The Dow and S&P 500 are also seeing big gains well. Chart 1 shows the S&P 500 up more than 48 points today (1.76%) in afternoon trading. Its 14-day RSI line (upper box) is bouncing off oversold territory at 30. In addition, the SPX is bouncing off potential chart support at its March low near 2722. Nine sectors are in the black today, with percentage gains in excess of 2% in technology, materials, financials, and cyclicals. Industrials are right behind. The only two sectors on the red are defensive utilities and REITS. Safe haven Consumer staples are also lagging behind.
Sectors Holding or
Regaining Their 200-Day Lines
Charts 2 and 3 show the Technology
and Consumer Discretionary SPDRS bouncing off their 200-day lines.
Semiconductors are leading techs higher, while autos are helping boost
cyclicals. Charts 4 and 5 show the Financial
and Industrial SPDRs climbing
back over their 200-day lines today. Banks are leading the financials higher. A
strong transportation group is boosting industrials. Chart 6 shows the Materials SPDR (XLB) also regaining its 200-day line. It’s
being led higher by stocks tied to copper. A rebound in bond yields is also
giving a boost to financial stocks, while hurting dividend-paying stocks, and signaling
some profit-taking in an overbought bond market. Increased hopes for a rate cut are
weakening the dollar and giving a boost to commodity prices.
Andrei Costas, Senior
Investment Analyst (Equity Strategies)
Nan Lu, Senior Investment
Analyst (Fixed Income Strategies)
1033 Exchanges: Tax Relief for Involuntary Conversions due toFire, Theft, Natural Disaster, Eminent Domain, Seizure and Condemnation
Authored By: Scott Bishop, CPA/PFS, CFP® and Michael Churchill, MSPA, CPA
Understanding the tax benefits of using Code Section 1033 of the Internal Revenue Code can help a taxpayer to defer what otherwise would have been a recognized gain due to an involuntary conversion of their property. A commonly used “cousin” to the 1033 exchange is a 1031 exchange, which also provides tax benefits for deferring the recognition of gain for the sale or property. The important difference between the two is that a 1033 event is unplanned or unexpected and the 1031 event is the opposite, hence the phrase “involuntary conversion.” Because of the planned nature of 1031 Like-Kind exchanges, there’s more structure to the process, limitations on what constitutes a Like-Kind exchange, and more stringent time frames to follow. Conversely, the 1033 exchange is much more flexible with far fewer restrictions and “red tape.”
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