(Bloomberg) — Warner Bros. Discovery Inc.’s junk bonds surged this week, handing big gains to investors that bet on the company when its future looked comparatively bleak. More such opportunities may be coming, according to money managers including Loomis Sayles & Co.
The entertainment company’s 5.05% notes due 2042 climbed more than 13 cents on the dollar on Thursday and Friday, to about 82 cents, amid reports that it might be bought by Paramount Skydance Corp., which has two investment-grade ratings. It’s a rapid turnaround for securities that were investment-grade earlier this year, but were cut to junk status amid Warner Bros. announcing it was splitting into two companies and refinancing a slug of debt.
Junk bond investors that are willing to quickly buy bonds from companies that lose their investment-grade status can often profit, said Loomis Sayles portfolio manager Eric Williams. Companies known as fallen angels tend to have relatively strong businesses compared with other high-yield firms. When a company is cut to speculative grade, high-grade investors often have to jump ship in a matter of days or weeks, while longer-term junk bond holders may take months to evaluate the debt and choose to buy it.
“When we look through that near-term volatility, we tend to see good companies — potentially with a bad balance sheet or that are more levered at a bad point in time,” Williams said.
There’s been a lot of this debt to buy: six issuers with notes worth about $57.4 billion have tumbled into junk this year, according to strategists at JPMorgan Chase & Co. this week, a significant portion of which was from Warner Bros. Fallen angel volume is on pace to be the highest in five years, according to Loomis Sayles.
And more trouble might be coming. This week’s record revision to US payrolls data, along with the highest jump in applications for unemployment benefits in four years, could signal economic pain ahead. At the same time, inflation data this week signaled that price pressures haven’t completely gone away, implying the Federal Reserve only has so much leeway to cut rates now.
“The clouds are on the horizon; the economy is moderating for sure and it’s going to get tougher for companies to stay in that BBB space probably,” said Paul Benson, head of systematic fixed income at Insight Investment.
The US high-grade corporate bond market is about $7.5 trillion, while the junk market is around $1.45 trillion. That translates to there often being fewer investors eligible to hold a company’s bonds when it loses its investment-grade status.
The potential turnaround for Warner Bros. has been quicker than usual. But there is a natural incentive for fallen angels to re-enter the investment-grade sector, said Insight’s Benson.
“These companies, having been born and bred in investment-grade territory, they have become very accustomed to funding themselves frequently and in size,” he said.
Of course, markets can underestimate risk. In recent weeks, strong demand has pushed junk bond risk premiums, or spreads, to the lowest levels in years. Investment-grade spreads are close to their tightest since the late 1990s, and the difference between many spread levels is close to the tightest on record, according to Bloomberg index data.
But there’s a history of fallen angels generating gains if trades are timed right, said Brian Gelfand, co-head of global credit and head of credit trading at TCW Group Inc. He views that to be before the companies are junked as the risk gets priced in.
“Once downgraded, they actually tend to perform quite well,” Gelfand said.
More stories like this are available on bloomberg.com
