Corporate bond buyers must heed fallen angel risk

LONDON (Reuters) - Corporate bond yields may seem attractive but investors should be wary given the risk of bonds being downgraded in some sectors, said Ben Bennett, credit strategist at Legal & General Investment Management.

He was referring to the risk of fallen angels which are bonds that are downgraded from investment grade to speculative grade.

If history is repeated, 15 percent of BBB credits -- those on the lowest rung of the investment grade universe -- may become fallen angels in 2009, Bennett said.

About 20 percent of the investment grade sterling corporate bond market is rated BBB.

"Cheap bonds are cheap for a reason, with the coming months set to witness a high number of downgrades and associated volatile price action," Bennett said at a briefing on Wednesday.

Because certain investors can only hold investment grade bonds, any downgrading from investment to speculative grade is usually accompanied by price falls. This is because the forced sellers invested in investment grade vastly outnumber the likely buyers in the speculative grade universe.

There have been anecdotal reports, however, of waves of retail money poised to invest in corporate bonds, whilst investment consultants have been advising institutional clients to consider increasing their corporate bond allocations.

This is because corporate bonds are thought to offer attractive yields, even factoring in a rise in defaults.

FAT TAIL

Conversely, Bennett cautioned that the concept of an "average yield" of say 5 percent over government bonds, as offered by the Lehman investment grade corporate bond index, is misleading, given the amount of bonds currently trading at distressed levels.

Investment grade bonds normally trade at around 100 percent of their notional value. However that is not the case at the moment.

For example on February 3, some 8 percent of bonds in the index were trading at 75 percent of their notional value, 7 percent were at 70 percent of notional value, 6 percent were at 65 percent, and 4 percent were at 55 percent of notional value. Some were trading as low as 25 percent of their notional value.

Fallen angel risk is concentrated in certain sectors -- particularly subordinated financials -- with basic industry, capital goods and consumer cyclicals also posing a medium to high risk.

"The task for active managers is to hold a core portfolio of non-cyclicals and add yield by dynamically managing cyclicals while avoiding fallen angels," he said.

"You need to find those bonds you think are mis-priced," he said. As an example he cited Xstrata (XTA.L), which had been trading very wide, then experienced a significant rally after it announced its rights issue.

"We would also be more comfortable with the Triple B utilities, although there is not much spread in them," he said. "I would be more concerned by the auto sector because the fall off in sales has been quite dramatic and the downgrades have come through very fast."

(Editing by Sharon Lindores)