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STA Weekly Report – Bonds: Do We Expect a Massive Wave of “Fallen Angels”?

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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.

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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.

Source: Bloomberg
Source: Bloomberg

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 yield.    

Source: Bloomberg

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.

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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. 

Weekly Global Asset Class Performance

If you have any questions, please feel free to email me at luke@stawealth.com.

Luke

STA Investment Committee

Luke Patterson, CEO & Chief Investment Officer

Andrei Costas, Senior Investment Analyst (Equity Strategies)

Nan Lu, Senior Investment Analyst (Fixed Income Strategies)


1033 Exchanges: Tax Relief for Involuntary Conversions due to Fire, 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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Important Disclosure:
Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by STA Wealth Management, LLC (“STA”), or any non-investment related content, made reference to directly or indirectly in this article / newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this article / newsletter serves as the receipt of, or as a substitute for, personalized investment advice from STA.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  STA is neither a law firm nor a certified public accounting firm and no portion of the article / newsletter content should be construed as legal or accounting advice.  A copy of the STA’s current written disclosure Brochure discussing our advisory services and fees is available upon request. Please Note: If you are a STA client, please remember to contact STA, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. STA shall continue to rely on the accuracy of information that you have provided.

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