Fallen angels radar: busy across sectors

In this issue of Fallen angels radar we provide a rundown of new fallen angels¹, and explain how our Fallen Angels Recovery strategy expands the universe of eligible bonds. We also discuss why the combination of a growth-positive agenda and considerable uncertainty created by the new US administration mean now is potentially an opportune time to invest in the asset class.

Read more: 3 years of catching fallen angels

Charting changes in the fallen angels investable universe

Traditionally a slow period for markets, the last few months have seen an unusually high level of activity in the fallen-angels universe. Bonds from names across multiple sectors joined the index², while one name fell lower into high yield and left the universe.

Prospect Capital Corp.³

Rationale for ratings action

Prospect Capital Corp. is a US-based business development company focused on making debt and equity investment in middle-market businesses across a range of sectors. S&P’s decision to downgrade was driven chiefly by ongoing deterioration in the company’s asset quality, together with greater exposure to payment-in-kind (PIK) notes and overall weaker performance relative to peers. Moody’s downgraded the company weeks later, citing similar concerns around PIK arrangements with weaker borrowers, along with lower earnings, higher investment losses and a poorer asset-to-debt ratio.

Longer term view

While these downgrades are justified given the contributing factors, we believe the outlook for the company is stable. Founded in 2004, Prospect Capital is a mature business with a diverse portfolio, including exposure to real-estate investment trusts (REITs), healthcare providers and consumer finance. It also benefits from an experienced management team, less than 1.5x leverage and strong liquidity of around USD 1 billion – versus debt maturities of less than USD 200 million over the next 12 months.

We note that Prospect had already been addressing the key issue of reducing its exposure to PIK notes, which fell from 18.6% to 16.9% of income between June and September 2024. Overall, with the firm’s USD 2.1 billion revolving credit facility (RCF) final maturity more than four years away, we believe the company will be able to overcome current challenges.

Lar España³

Rationale for ratings action

Fitch’s downgrade of Spanish REIT Lar España Real Estate SOCIMI (LRESM) was prompted by the plans of its new private owners. To finance a tender offer for shares, Hines European Real Estate Partners III and Grupo Lar announced their intention to re-leverage the company to around 60% loan-to-value (LTV). The new owners’ re-leveraging strategy requires major debt restructuring and will result in a significant rise in the company’s average cost of debt. According to Fitch’s calculations, this will result in a net-debt to EBITDA ratio of 12.5x by the end of 2025, with a much tighter interest coverage ratio of 1.4x (compared to 5.2x in 2023).

Longer term view

In our view, LRESM will be left with considerably less financial flexibility in the wake of the deal.  LRESM has two bonds outstanding (1.75% notes due 07/22/2026 and 1.843% notes due 11/03/2028). Both are priced around par and yield just 2%⁴ – not what we would usually expect for a recently downgraded fallen angel, let alone one that has been downgraded four notches instead of the more typical single notch. This unusual price action reflects the inclusion of a change of control clause in the bond documentation which is triggered by this transaction; the clause allows bondholders to put the bonds back to the company at a price of 101 once the transaction to take the company private has gone through. Any bonds not put back to the company (which will be a very small quantity) are highly likely to reflect the increased risk associated with the rating and have a much greater yield or lower price than they do now, in our opinion.

Hella GmbH & Co. ³

Rationale for ratings action

German auto parts supplier Hella is around 82% owned by French firm Forvia, so when its parent company was downgraded in October it was only a matter of time before Hella suffered a similar fate. Moody’s confirmed that the downgrade was driven by Forvia’s weakened credit profile, while maintaining a two-notch difference due to Hella’s stronger metrics.

Longer term view

Given Forvia’s significant controlling stake we believe the two companies should be rated equally, since Hella is no longer an independent concern. The firm has just one bond outstanding, (0.5% notes due 01/26/2027); no price action was in evidence in the wake of the downgrade. With this asset yielding less than an equivalent Forvia bond – we believe there is little value on offer.

Service Properties Trust³

Rationale for ratings action

Moody’s decision to downgrade this US hotel and retail focused REIT was based on very high leverage and weak fixed charge cover, in turn caused by poor operating performance and deteriorating cash flow. Given the very limited headroom offered by the company’s bond and RCF covenants, there is also concern around whether it can refinance in the near term as its debt matures.

Longer term view

Our concerns relating to the company date back several years. In early 2023, our analysis raised issues around governance, business strategy and inconsistent financial policy that could impact the firm’s ability to refinance near-term debt maturities and potentially make it a falling knife. Falling knives are fallen angels that continue to suffer from a decline in creditworthiness. As such, the deterioration in the company’s situation is unsurprising. 

Aptiv³

Rationale for ratings action

Auto-parts supplier Aptiv announced a plan to spin off its Electrical Distribution Systems subsidiary into a separate company by March 2026. As a result, Fitch placed its BBB ratings on review for downgrade. It also downgraded the subordinated bonds by one notch to high yield, to more closely align the rating with similar instruments; this effectively acknowledged the previous rating was incorrect. Both Moody’s and S&P’s ratings remained unchanged. 

Longer term view

We expect the bonds to remain at Aptiv, which we believe is likely to maintain its investment grade rating. That would support a stable BB or BB+ rating for the subordinated bonds.

Top of mind: liquidity

In this section, we answer the most common question we have received over the past quarter about investing in fallen angels.

Question:

“How does BWB’s approach to fallen angels increase liquidity in the segment?”

Answer:

The fallen angels index comprises bond issuances that have been recently downgraded from investment grade to high yield. Our Fallen Angels Recovery strategy expands the universe to include any bond from a fallen angel issuer, whether the specific bond has been downgraded or not. This increases the overall size of the investible universe, enhancing fund liquidity and potentially reducing trading costs.

Read more: 4 passive pitfalls: why fallen-angels bonds need active management

What’s the outlook for fallen angels?

While monetary policy will remain important in 2025, it’s already clear that trade tariffs and fiscal policy will play an increasing role at a macro level – with important implications for fixed-income markets. These factors are likely to lead to a divergence in the growth and inflation trajectories of the US and Europe.

By comparison with 2024, which offered up some exciting opportunities to take advantage of spread tightening in sectors like real estate, the performance drivers look less obvious in 2025. Indications are that it will be a year of ‘carry’, but our years of experience suggest there will be unexpected shocks – and we need to be ready to take advantage, wherever they come from. While the shock tactics of the new US administration – particularly around tariffs – are generating a lot of headlines, the impact on credit markets is likely to be relatively muted given the lack of follow-through so far. Nevertheless, we are monitoring the situation carefully and suspect the opportunities may lie in the second order impact of these policy changes, rather than in those issuers directly impacted.  

The uncertain but growth-positive environment is favourable for quality corporate bonds, which we believe currently offer a better mix of credit and duration risk than government bonds. In particular, corporate debt offers interesting opportunities at the higher quality end of high-yield credit, where fallen angels are to be found – offering the potential for wider spreads and the potential for strong returns.

One sector we have flagged previously that continues to face challenges is automotive. More sluggish than hoped for electric vehicle uptake in some markets is affecting overall production volumes, with component manufacturers most vulnerable to the consequences.