Note: This article is courtesy of Iris.xyz

By Mark Germain

“Fallen angels.” It sounds like a catchy title of a John Grisham novel. It’s not, but maybe some day it will be, if you could work a mysterious murder involving a bond trader into the plot.

A fallen angel is a bond that began its life with an investment-grade rating (i.e. a Standard and Poors BBB rating or above), but was subsequently demoted from angel status.

Often a fallen angel will, before dropping from investment heaven, start out with a very long-term high rating–possibly AAA. Then, the issuer has gone through a shaky period, leading to a downgrade, or a series of downgrades. But when looking at the situation, it’s important is to make a careful distinction between the fallen angel bond itself, and the issuer.

It is not the issuer that’s the fallen angel, but the specific bond issue at hand. That means that the issuer’s fortunes could improve, and goes back to the bond market with a new offering that receives an investment grade rating, even as the earlier “fallen angel” bond is still bearing a lower credit rating.

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Fallen angels are sometimes known by a less attractive name, high yield, or “junk” bonds. Technically, “junk bonds” are those that had a sub-investment grade credit rating at birth; i.e. they weren’t born in bond heaven. According to Morningstar, fallen angels make up 13% of the broader U.S. high-yield universe.

The main point is “junk” doesn’t mean the bond has should be shunned at all costs. Yes, they sometimes do go into default–but that’s relatively rare.

Risk and Reward

Fallen angels are, of course, not risk-free (hence their higher yield), and do not belong in everyone’s portfolio. In any case, a properly diversified portfolio would never be dominated by fallen angels.

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