* Investors now focus on potential fallen angels
* Automakers, retail, building materials seen as candidates
* Big jump in spreads follow rating downgrades
By Jane Merriman
LONDON, March 2 (Reuters) - The economic downturn will drive more European corporate bonds into the ranks of "fallen angels", an opportunity for investors as they try to guess whose will be downgraded next after Renault and Fiat.
Companies become fallen angels when they lose their investment grade rating to become speculative grade or junk. Although spreads often widen in anticipation of a rating downgrade, the fall to junk status itself usually triggers a further sharp move.
"We have numerous credits now on the verge of fallen angel status that have not yet fallen," said Peter Aspbury, head of high yield research at European Credit Management.
"Give it another quarter or so, and you will have even more of the (European) auto sector below investment grade, plus further downgrades in basic materials and retail for example," he said. "There will be better pickings for fallen angel investors at that point."
A move to junk drives down the price of a company's bonds and raises its borrowing costs, because it is seen as more risky in terms of a potential default.
Investors can bet that a potential fallen angel avoids the drop, by simply buying its low-priced bonds. They can also make money on those that do, by using credit default swaps (CDS) to buy protection against the company's default -- a contract that rises in value as spreads widen.
The economic downturn has turned 75 companies globally into potential fallen angels, the highest number in 18 years, according to Standard & Poor's. S&P defines potential fallen angels as companies rated BBB- with a negative outlook.
This compares with a monthly average of 47 potential fallen angels in 2008, S&P said.
Barclays Capital estimates that European companies with about 55 billion euros of bonds outstanding could be potential fallen-angel candidates because of the global economic downturn.
"We expect that 41 billion euros ($52.1 billion) worth of bonds are likely to go junk, while 14.7 billion are possible but not likely," Barclays said in a note.
Europe's high-yield market, where junk bonds are traded, is small compared to that of the United States and has had only one new issue -- by German healthcare group Fresenius -- since the start of the credit crisis in July 2007.
"The big source of growth in the high-yield market will be the new supply through fallen angels," said Mahesh Bhimalingam, a Barclays high-yield credit strategist.
DOWNGRADE SIGNALS
Some European retailers, including Kingfisher, Marks and Spencer and PPR are already trading in the credit derivatives markets at levels that signal a downgrade.
Five-year credit default swaps on French retailer PPR were at about 557 basis points on Monday, a level analysts see as already pricing in a downgrade. PPR is rated BBB- by Standard & Poor's.
"The UK retail sector is expected to face particularly challenging trading conditions in the months ahead," CreditSights said in a research note. "Cross-over concerns center on Kingfisher and Marks and Spencer."
When downgrades occur, spreads can widen more sharply, even though the market had anticipated it.
This is partly because many investors are restricted by investment mandates to hold only investment-grade assets, and so are forced to sell after a downgrade.
"Even if they (the markets) are pricing in a downgrade, the chances are it's not enough," said Ben Bennett, credit strategist at Legal & General Investment Management.
Five-year CDS for Renault, for example, were trading at around 440 basis points on Feb. 20 before it was downgraded by Moody's Investors Service to Ba1, one level below investment grade. They have since jumped wider to around 568 basis points.
The spread on Renault's bond maturing in 2010 almost doubled to 472 basis points from 250 basis points.
"This underlines the need for state aid to provide junk-rated companies with access to capital," said Frank Hussing, credit analyst at Commerzbank in a note.
An investor can profit from the widening spread by buying protection in the credit default swaps market. Or investors can try to pick companies that come close to a downgrade but then take steps to avoid it.
"From an active fund manager point of view, the aim is to try to pick those who perhaps will avoid the drop to fallen angel -- by doing a rights issue," said Bennett.
Last month, French building materials company Lafarge tapped shareholders for an additional 1.5 billion euros to bolster its finances and strengthen its credit ratings. Standard & Poor's revised its outlook on Lafarge's BBB- rating to stable from negative following the issue.
Investors are more likely to shun the debt of high-risk fallen angels in the current uncertain economic environment, while record volumes of new issues in the euro bond market so far this year give them plenty to choose from.
"Yields on primary investment grade bond issuance are so attractive and tend to be more liquid that it makes secondary fallen angel paper less appealing," said Aspbury. ($1=.7865 Euro) (Additional reporting by Jane Baird and Natalie Harrison; Editing by Andrew Callus and Jon Loades-Carter)