Among fixed-income assets, fallen angel bonds and related exchange traded funds have been an outperforming theme as energy and basic industry sectors helped drive returns.
Over the past year, the VanEck Fallen Angel High Yield Bond ETF (NYSEArca: ANGL), which tracks the BofA Merrill Lynch US Fallen Angel High Yield Index, climbed 32.3%, compared to the Bloomberg Barclays US Aggregate Bond Index’s 1.2% return.
Supporting the outperformance, ANGL’s underlying index includes a hefty tilt toward energy and basic industry sectors, which have strengthened on the back of a strong rally in commodities that began in the first quarter and continued through the year, Meredith Larson, Product Manager of ETFs at VanEck, said in a note.
ANGL includes a 27.7% weight in energy and 24.8% in basic materials. Its overweight position in energy helped the ETF outperform as crude oil prices rebounded from multi-year lows back in the first quarter of 2016.
In the fourth quarter, fallen angels managed to outperform the broader high yield universe due to their energy sector overweight and healthcare sector underweight – ANGL does not include healthcare sector exposure.
“We think this marginal outperformance is noteworthy given that 5-year U.S. interest rates rose 75 basis points (bps) in the quarter,” Larson said. “The sector differentiation of fallen angels offset the relatively higher interest rate duration risk they tend to average versus broad market high yield bonds.”
ANGL has a notably longer duration of 6.29 years – duration is a measure of a bond fund’s sensitivity to changes in interest rates, so a longer duration translates to greater interest rate risk.
The fallen angel ETF tracks so-called fallen angel speculative-grade rated debt, or debt securities that were initially issued with an investment-grade rating but were later downgraded to junk territory. Fallen angel issuers tend to be larger and more established than many other junk bond issuers.
“The 2016 story highlights not only the recent positive impact of fallen angels’ sector differentiation, versus broad high yield, but also the contrarian investment mechanism associated with tracking an index of fallen angels,” Larson said. “For example, fallen angels benefited in 2016 from the tendency to be oversold leading up to their downgrades to below investment grade ratings. Approximately 35% of the Index’s market value comprised 2016’s fallen angels at the time of their entrance.”
Furthermore, since these fallen angels were formerly on the cusp of investment-grade status, the group of junk bonds typically has a higher average credit quality than many other speculative-grade debt-related funds. The higher average quality also helped absorb some of the market volatility we experienced last year.
Looking ahead, fallen angels may experience increased volatility, especially with interest rates expected to rise.
“We expect that fixed income markets will be more volatile this year,” Larson added. “Given the rising and potentially more volatile rate environment, we predict that 2017 will be more about having an income cushion to offset rate moves.”
For more information on fixed-income assets, visit our bond ETFs category.
CORRECTION: Angel bond performance relative to broader high-yield bonds.