Corporate bonds and the related exchange traded funds often feature higher yields than Treasuries and those yields go up as investors go down the ratings spectrum. For example the iShares U.S. Fallen Angels USD Bond ETF (NASDAQ: FALN) has a 30-day SEC yield of 5.67%.

FALN, which recently turned three years old, seeks to track the investment results of the Bloomberg Barclays US High Yield Fallen Angel 3% Capped Index composed of U.S. dollar-denominated, high yield corporate bonds that were previously rated investment grade. The fund generally will invest at least 90% of its assets in the component securities of the index and may invest up to 10% of its assets in certain futures, options and swap contracts, cash and cash equivalents. The index is designed to reflect the performance of U.S. dollar denominated, high yield corporate bonds that were previously rated investment grade.

The $100.5 million FALN holds nearly 240 fallen angel bonds and has an effective duration of 5.63 years.

FALN “offers low-cost, broad market-value-weighted exposure to fallen angels, which represent an attractive area of the high-yield market,” said Morningstar in a recent note. “Fallen angels are bonds that were investment-grade when they were first issued, but their quality has since slipped below investment-grade.”

Focus On FALN ETF

Fallen angel issuers tend to be larger and more established than many other junk bond issuers. 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.

“Fallen angels are more likely to be undervalued than original-issue high-yield bonds when they first fall below investment-grade,” said Morningstar. “That’s because there’s considerable forced selling pressure when these bonds are downgraded below investment-grade, as a lot of investment-grade investors aren’t permitted to own lower-quality bonds. This fund is refreshed monthly, which allows it to quickly pick up these bonds after they fall below investment-grade and benefit from the potential mispricing from this forced selling pressure.”

Importantly, there are long-term benefits to owning a fallen angel bonds or a fund such as FALN.

“Fallen-angel issuers have also enjoyed higher rates of upgrades back to investment-grade than other types of high-yield bond issuers,” according to Morningstar. “These bonds also tend to have a higher-quality orientation than the broad high-yield bond market, which gives this fund less exposure to the most speculative issues in the market. That said, fallen angels do tend to carry greater interest-rate risk than most original-issue high-yield bonds, owing to their lower coupon rates, which tends to give them a longer duration.”

For more on alternative investment strategies, please visit our Alternatives Channel.

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