The Making of Fallen Angels—and What QE and Credit Rating Agencies Have to Do with It

Viral Acharya
By Viral Acharya, Ryan Banerjee, Matteo Crosignani, Tim Eisert, and Renée Spigt
Riskier firms typically borrow at higher rates than safer firms because investors require compensation for taking on more risk. However, since 2009 this relationship has been turned on its head in the massive BBB corporate bond market, with risky BBB-rated firms borrowing at lower rates than their safer BBB-rated peers. The resulting risk materialized in an unprecedented wave of “fallen angels” (or firms downgraded below the BBB investment-grade threshold) at the onset of the COVID-19 pandemic. In this post, based on a related Staff Report, we claim that this anomaly has been driven by a combination of factors: a boost in investor demand for investment-grade bonds associated with the Federal Reserve’s quantitative easing (QE) and sluggish adjustment of credit ratings for risky BBB issuers.

The Funding Privilege of Prospective Fallen Angels

The BBB segment of the corporate bond market has ballooned since the Global Financial Crisis, as shown by the chart below. The amount outstanding of BBB-rated corporate bonds has more than tripled since 2009 to account for more than half of all investment-grade debt in 2020, up from 33 percent in 2008. The growth of the BBB market has been particularly pronounced among issuers hovering just above the investment-grade threshold of BBB, firms at risk of becoming fallen angels upon a downgrade. Notably, these prospective fallen angels experienced a substantial reduction in their bond financing costs even as their balance sheets became more fragile.

The chart below shows the bond spread between downgrade-vulnerable and non-downgrade-vulnerable issuers by rating (see the associated working paper for a formal definition of downgrade vulnerability). Prospective fallen angels paid 13 basis points less to borrow in the corporate bond market as compared with safer BBB-rated issuers. If prospective fallen angels had been downgraded below the BBB rating, their funding costs would have risen by around $300 billion over the period from 2009 to 2019, according to our back-of-the-envelope calculations. This phenomenon is unique to BBB-rated issuers and particularly pronounced from 2013 to 2016, a period coinciding with a rapid, QE-driven expansion of the Federal Reserve’s balance sheet. We do not observe a similar subsidy in the high-yield corporate bond market (for corporate bonds rated below BBB), in equity markets, or in the corporate loan market.

Read the full Liberty Street Economics article.

Viral Acharya is the C.V. Starr Professor of Economics