**The pressure on credit ratings is leading to a renewed focus on “fallen angels”.**<sup>**5**</sup> JP Morgan, for example, expects about 14 percent of EM corporate investment grade (IG) bonds in the CEMBI Broad and EMBIG quasi to migrate to non-investment grade in 2020. This compares to the previous peak reached in 2015, when the sovereign downgrades of the Russian Federation and Brazil triggered a large magnitude of “fallen angels”. So far in 2020, over 7 percent of the investment grade universe has fallen to non-investment grade, which has also been driven by the downgrade of Pemex, the Mexican state-owned oil company in April 2020. A more adverse case assuming all BBB-rated bonds fall to non-investment grade would result in circa 20 percent of investment grade issuers migrating to non-investment grade.

**The downgrade to non-investment grade can lead to forced selling by investors whose investment decisions are indexed to various investment indices. Based on the latest JP Morgan figures,** benchmarked investors hold around 15 percent of EM corporate BBB bonds outstanding or about US$ 93 billion. In a downgrade scenario, and assuming investors could retain some of these now non-investment grade bonds, one can estimate that forced selling for the remainder of year could amount to at most US$ 6 billion.<sup>6</sup>

**The number of downgrades during negative rating cycles tends to be dominated by highyield (HY) issuers, which is not surprising given the greater vulnerability in times of stress (Exhibit 1) that generates higher risk premiums.** This was the case in both major downgrade periods of 2008/2009 and 2015/2016 and is also evident in the current cycle.<sup>7</sup> Given the latest changes in market conditions, investment banks and credit rating agencies expect the average EM corporate HY default rate over the next 12 months to be between 5 and 13 percent, which compares to the 10.5 percent reached in 2009. Corporate default rates are driven by particular geographical regions, with corporates exposed to the pandemic in Middle East & Africa (also oil) and Latin America likely to see the highest defaults. Based on market analysis, the volume of bonds trading at or below US$70 now accounts for 10.6 percent (14.7 percent in March 2020) of non-defaulted EM HY corporate bonds versus 13.9 percent at the peak of the 2016 sell-off. Bonds trading at or below US$ 50 now account for 4.0 percent, which is still somewhat lower than 6.0 percent at the 2016 peak. The main difference from the 2008 crisis is that the current episode is not triggered by a banking or financial crisis, although default rates could increase in the event of a more systematic crisis or prolonged lockdown scenario.

> 5 Some developed market central banks (CBs) have or are looking at ways of alleviating the impact of such downgrades. For example, some CBs have already loosened collateral requirements monetary policy operations to account for such downgrades, which may help limit excessive market volatility following a rating action. Extending such central bank arrangements to EMDEs may be challenging given more constrained monetary policy frameworks and central bank balance sheets.

> 6 Dependent on valuations and market conditions. 7 Based on JP Morgan analysis of credit rating actions as of May 31, 2020. The number of 12-month rolling downgrades from investment grade is now around 50 compared to between 100 and 150 in early 2016. For HY, the corresponding number is at 304 which exceeds the peak level reached in 2016 and is close to the GFC peak of 414.

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