An angel falls from auto heaven

About $10bn of Nissan Motors bonds will slide into high-yield bond markets in April, after S&P Global Ratings downgraded the automaker this week.

Nissan will be the biggest issuer to qualify as a “fallen angel” — a company whose debt gets downgraded to junk after spending time in investment-grade — since the early weeks of the US’s Covid-19 pandemic in April 2020, according to strategists at Bank of America.

In a Tuesday note, the bank argues that this is no big deal for broader markets.

Despite the increasingly hawkish outlook for the Fed, we view this downgrade as a one-off and expect relatively benign fallen angel volumes this year for three reasons.

First, during past periods of heavy downgrades over half of fallen angels have been concentrated in a single stressed sector . . . In contrast no sector is distressed now, and we expect that to continue as the economy slows due to tighter monetary policy. The lack of distress should limit the downgrades to HY this year.

The strategists also include this handy table:

But are there really no problem sectors right now?

Automakers don’t seem to be doing especially well at the moment. Here’s part of what S&P Ratings says prompted the Nissan downgrade in a FAQ, with our emphasis:

Initially, we assumed there would be a prompt earnings recovery for Nissan Motor. When we downgraded the company to ‘BBB-’ in July 2020, we reflected into our rating the prospect that its profitability will recover to the level of similarly rated peers such as US- based Ford Motor Co. and France-based Renault S.A. within one to two years.

We also assumed that the company’s strong net cash position under conservative financial discipline would enable it to withstand difficulties. Our views have changed. A strong earnings recovery has yet to emerge at the company, though we forecast its auto business will become profitable in second half of fiscal 2022. In addition, its global car sales have continued to decline despite steady progress reforming business and introducing new models. The prolonged Russia-Ukraine conflict, the global economic downturn, high raw material prices, and the rapid shift of global demand to electric vehicles (EVs), are also headwinds for Nissan Motor. These factors have led us to view conditions for the entire automotive industry as much worse than we previously assumed.

On the bright side, there simply aren’t that many US-based automakers left to be downgraded to junk.

Ford is junk-rated and caught in a price war with Tesla, which isn’t investment-grade rated either. General Motors’s ratings have held up better, but its composite credit rating remains just one tier above junk. (This all excludes captive-financing arms and ABS, since they have different credit considerations.)

There are at least a couple of international automakers in the lowest three tiers of investment grade that could be a source of concern (Hyundai and Kia, for example). But GM is the biggest to worry about for US investors, and it doesn’t seem to be at risk of a junk rating yet.

Bank of America has other reasons investors shouldn’t worry about fallen angels, of course:

Second, the US economic slowdown is expected to be relatively benign. That is because the outlook for weaker growth is driven by Fed policy, which means the Fed can ease policy if the economy slows too much.

Well . . . ideally the Fed’s tightening cycle will work that way. But as Sen. Elizabeth Warren said to Fed Chair Jay Powell during his testimony Tuesday, that isn’t a given.

Third, market pricing and rating agency data point to limited near-term downgrade risk. Currently 0.8% of IG index, or $55bn, trades at BB-spreads. That share is historically correlated with downgrades to HY over the following six months . . . Finally, the volume of both low-BBB and mid-BBB issuers on a negative watch or outlook remains near historically low levels.

The strategists’ final point, found above, is rather more convincing.

“Fallen angel” bonds tend to trade at junk-level spreads in the months leading up to their downgrades. In fact, not only are ratings firms slow in cutting companies to junk, they usually put the borrowers on negative watch — or at least negative outlook — for a while beforehand.

So the following chart from Bank of America does provide some comfort:

But the Fed is turning up the policy temperature, and could pick up the pace depending on the strength of data on jobs and inflation (this Friday and next Tuesday, respectively). And it’s often tough to tell which sectors will be affected, or how badly, until markets are already in a panic.