Investing in fallen angels: What to know

Summary:

  • Fallen angels are one of the most inefficient spaces in the corporate credit market.
  • Performance of the segment followed our expectations once again in 2020.
  • Fallen angels can perform poorly in weaker credit markets so they must be managed in an overall portfolio context.
  • Fallen angels have good characteristics.
  • Fallen angels are an excellent strategic portfolio tool, but we believe active management of the strategy is optimal.

Not all credit is created equal and some parts of the corporate bond market are more inefficient that others. Fallen angels are one of these areas. Fallen angels are bonds of companies downgraded from an investment grade rating, that became high yield securities after the issuers were downgraded.

2020 once again reinforced this position, as the ICE BofA U.S. Fallen Angels High Yield Index outperformed the ICE BofA U.S. High Yield Index by 8.9%, and the ICE BofA U.S. Investment Grade Index by 5.2% in U.S. dollar terms. 

The fallen angels index is by definition an index of U.S. high yield bonds. Unsurprisingly, it tends to underperform U.S. investment grade bonds in poor credit markets, while outperforming in positive credit markets. However, fallen angels stand out when compared with U.S. high yield bonds, as they’re historically one of the best performing parts of the U.S. bond market. Investors looking at fallen angels when compared to U.S. high yield bonds will observe that they tend to outperform over most one–year time frames.

Fallen angels had a similar experience to the broad U.S. high yield index last spring, when credit spreads widened dramatically in March of 2020 as COVID–19 took hold. However, the real benefit in fallen angels for portfolios occurred once the selloff stopped. Aggressive fiscal and monetary policy action followed the March 2020 selloff, leading to credit stabilizing and starting to recover. Notably, this recovery was most pronounced in the fallen angels segment.

Fallen angels’ performance versus U.S. investment grade bonds also reversed and the outperformance versus high yield has continued. This pattern has proved to be predictable, and for good reasons—which investors should pay attention to.

Click image to enlarge

Fallen angels excess performance

Why has this occurred?

The theory behind investing in fallen angels is that as a high yield bond transitions from investment grade to high yield, there is a natural switch in the ownership of these bonds from investors who are averse to default risk to investors who are more accustomed to pricing default risk. This period of transition creates credit mispricings.

However, the most powerful thing that makes fallen angels perform is a natural rebalancing mechanism that populates a portfolio with bonds that have abnormal upside potential relative to their downside.

Newly fallen angels have lower bond prices than equivalent credit quality bonds that were originally issued in high yield, even though they have similar yields. This is because when they were originally issued as investment grade bonds, they had lower coupons than high yield bonds. As they become fallen angels and their yields trade in line with other BB–rated credits, bond math requires the bond price to fall to lower levels than their high yield counterparts for this to occur.

This lower bond price is important because corporate bonds have only two potential outcomes:maturity at par or default.

Fallen angel
with low coupon
                          High yield issued bond
with higher coupon
 
Current  15-Apr-21  Current 15-Apr-21
Maturity  15-Apr-31  Maturity 15-Apr-31
Coupon 3% Coupon 5%
Price  56.62 Price 69.31
Redemption  100 Redemption 100
Yield  10% Yield 10%
Loss if recovery rate = 40%  29% Loss if recovery rate = 40% 42%

In this example two bonds have the same yield (10%) and maturity date; however, the fallen angel has a lower coupon

A bond facing a default will lose the difference between its price and the recovery value. Therefore, if an investor expects a credit to default, they would lose less if they buy the lower–priced bond.  However, if the bond was to survive and mature, the price would rise at some point to par.  This means that the upside versus downside potential for two similar credits with the same yield and underlying credit risk is always better for the lower–priced bond. 

Ultimately, buying a fallen angels strategy is a way to actively rebalance to low dollar–priced credits which have better risk reward. The technical bond term that describes this better upside versus downside is convexity. Fallen angels are a natural strategy to rebalance into convexity.

How can fallen angels be used in a portfolio?

In spite of fallen angels having good genes, they have different characteristics than other bonds in the high yield universe that investors should be careful about.

We have mentioned before that fallen angels tend to have long maturities. The
ICE BofA Fallen Angels index has an average duration* of 6.7 years versus 4.1 for the ICE BofA US HY index. The decline of interest rates in 2020 has contributed positively to the outperformance of fallen angels versus other high yield bonds due to the longer duration, and therefore could be a risk during this period of reflation. 

Additionally, investors should be aware that while fallen angels have higher credit quality (BB biased) than the average index, their market sensitivity is at least as high as the broader high yield index. Therefore, in rich markets when there is little value, fallen angels’ return potential does not stand out.

Ultimately, we think that fallen angels will continue to outperform in the long run and have a strategic role in some credit portfolios. Common wisdom holds that when corporate bonds are downgraded below investment grade status, some investors are forced to sell their fallen angels because of explicit constraints on the ability to hold non–investment grade bonds. While this is likely a contributor to their attraction, this segment of the market also has market structure issues that create better risk–adjusted opportunities.  However, care should be taken in portfolio construction as fallen angels come with some pronounced differences from traditional high yield credit.


* Duration is a measure which can be used to assess how sensitive a fixed income sector is to changes in interest rates.