Investors buy debt of companies poised for pandemic rebound

New York

WALL Street is backing a potentially lucrative trade betting on companies poised to win back investment-grade ratings in Europe's accelerating economic recovery.

Pacific Investment Management Co (Pimco) and JPMorgan Chase say buying the debt of companies on the cusp of an upgrade has the potential to unlock profits. And in the wake of a pandemic that saw a record number of companies tumble into junk territory, the strategy - known as rising-star investing - has rarely looked so promising.

The trade has decades of business-cycle history behind it, and Pimco projects as much as 200 basis points of outperformance over the average three years it takes to exit junk.

That is nothing to sniff at in a market where negative yields on corporate debt are commonplace.

Smurfit Kappa Group and Stellantis are part of the 12.5 billion euros (S$20 billion) stockpile of debt that has already made the jump to high grade this year. Strategists at JPMorgan are forecasting the 2021 tally of rising stars at a record 30 billion euros - comprising almost one-tenth of securities ranked "BB".

"As vaccination efforts ramp up globally, and economic growth looks set to accelerate, we think the focus will increasingly shift toward the upgrade cycle and rising stars as we enter the second half of the year," wrote JPMorgan credit strategists led by Madhubala Sriram.

Candidates for upgrade include Valeo and ArcelorMittal, said a note published by the US bank last week.

Investors in rising stars can make attractive returns if they anticipate an upgrade before it is priced in by the broader market. That is particularly valuable at a time when investors are struggling to meet targets as the European Central Bank floods the markets with liquidity, pushing yields to near historic lows.

"Given those generic credit valuations are less attractive, now is the time also to move away from passive indexing and focusing really on bottom-up security selection, finding those rising stars," Eve Tournier, head of European credit portfolio management at Pimco, said in an interview on Pimco's website.

"BB" rated bonds, which are the highest rung of the junk-rated universe, yield about 2 per cent. That is about four times that of "BBB" investment-grade notes, Bloomberg Barclays index data showed.

The road to recovery may be trickier for some.

Vaccinations and travel certificates are reviving the tourism industry after a disastrous 2020, for example, but the Delta variant of the virus is threatening to upend progress. ING Groep strategists warned earlier this year of more fallen angels - companies set to lose investment-grade credentials.

Still, the overall ratings picture is improving as corporate earnings return to pre-pandemic levels. Companies have also taken steps to shore up their balance sheets, such as reducing costs, selling non-core assets or raising equity.

Even airlines such as Deutsche Lufthansa and British Airways, owned by IAG , should be able to "claw their way back at some stage", said Roman Gaiser, head of fixed income and high yield EMEA at Columbia Threadneedle Investments.

"The market will likely be seeing a fair amount of rising stars over next 18 months, and we expect more rising stars than fallen angels," he added. BLOOMBERG