By William Sokol
Senior ETF Product Manager
Van Eck Associates Corporation
As we mark ANGL’s 10-year anniversary, this Q&A explores why we launched the fund, its track record, and our outlook for this space.
When the VanEck Fallen Angel High Yield Bond ETF (ANGL) was launched 10 years ago, it was the first to open up access to the fallen angel segment of the high yield bond universe. As we mark ANGL’s 10-year anniversary, this Q&A explores the fund’s beginnings and how it exemplifies the firm’s guiding principle. We also examine the traits that set fallen angel bonds apart from the broad high yield bond universe, how these unique characteristics contributed to its track record, and our outlook for this space as we enter a rising rate cycle.
- Q: Why did VanEck decide to launch ANGL 10 years ago?
- Q: What are “fallen angel” bonds and how does a fallen angel exposure differ from traditional high yield beta exposure?
- Q: The first quarter of 2022 was characterized by a hawkish Federal Reserve (Fed) and rising bond yields, impacting the entire spectrum of fixed income investments. How have fallen angels performed compared to broad high yield bonds to start 2022, and more broadly speaking, during periods of rising rates historically?
- Q: With spreads at or near historic lows, are investors currently being compensated appropriately for owning high yield in portfolios?
- Q: The ongoing geopolitical situation between Russia and Ukraine continues to agitate markets around the world. How can a portfolio of fallen angel bonds help maintain current income while moving up the credit quality spectrum?
- Q: One other potential source of total return within fallen angel bonds comes from “rising stars” – that is, bonds that regain investment grade status. How have rising stars historically performed and what is the potential for rising stars in the portfolio as it stands today?
Q: Why did VanEck decide to launch ANGL 10 years ago?
A: VanEck is guided by a mission to help investors build stronger portfolios by offering intelligently designed solutions, and that has been true since the company was founded in 1955. That can mean identifying segments of the market that offer unique value, even in traditional asset classes. High yield bonds are attractive because of the higher levels of income they can provide, but we felt that fallen angel high yield bonds have several unique characteristics that can make them compelling relative to a broad based exposure within an income portfolio. Fallen angels are a well-known phenomenon in the high yield market, but investors at the time didn’t have a way to control their allocation to this market segment. More commonly, investors might have had a small exposure within an actively managed high yield bond strategy, and we felt that the ability to gain pure exposure through a transparent, efficient and liquid vehicle would be an attractive offering. And that’s what led to the launch of ANGL 10 years ago.
The fixed income ETF market has grown tremendously and evolved in the past decade, but our guiding principle of providing access to these unique opportunities is the same as it has always been. Today, ANGL is the largest and most liquid ETF providing exposure to fallen angel high yield bonds. The ETF has a five star rating from Morningstar and is ranked #1 among all U.S. high yield mutual funds and ETFs over the life of the fund.i We’ve seen both rising rates and declining rates, extremely wide and tight credit spreads, and several bouts of volatility over the past decade. Through these market cycles, fallen angels have outperformed the broad high yield market consistently and significantly, with outperformance in eight of the nine full calendar years since ANGL’s launch, with an average of over 400 basis points in those years.ii
Q: What are “fallen angel” bonds and how does a fallen angel exposure differ from traditional high yield beta exposure?
A: When we talk about fallen angels, we’re referring to bonds that were originally issued with investment grade ratings and subsequently downgraded to high yield. They are part of the broader high yield market, making up about 10% currently, so it’s a small subset of the broad market.iii
But fallen angels are a distinct segment and have consistently outperformed the broader market over the past two decadesiv because of the unique attributes they have, which result from the crossover between investment grade and high yield.
That delineation is in some ways arbitrary and created by the boundary between the BB+ and BBB- ratings that separates the two markets, which have very different issuers and different investors. The investment grade market is much larger. When an investment grade issuer is expected to be downgraded, a lot of investors sell the bond because they cannot or will not hold a high yield security. Keep in mind that an issuer that’s expected to be downgraded is likely going through some rough patch for one reason or another, and investment grade investors may want to cut their losses.
We know that rating agencies tend to lag the market, so the selling by investment grade investors typically occurs prior to the downgrade. We’ve historically seen, as a result, about an 8% price decline prior to the downgrade.v And further, we typically see a full recovery in price within six months after the downgrade, indicating that those bonds were oversold. In other words, this is a structural anomaly and one that has been persistent over time. ANGL tracks an index that systematically buys these bonds when they are downgraded. That typically occurs when the price bottoms out, and this strategy has historically benefitted from the price recovery after purchase. Contrast that to a broad high yield strategy that would typically buy a newly issued bond around par. So that’s an important source of outperformance – the price appreciation of buying discounted bonds.
There are other unique characteristics as well. ANGL tends to be tilted towards higher quality bonds than the broad market, with currently about 90% rated BB (the highest quality rating within high yield) versus about 52% in the broad market.vi That’s currently higher than the historical average, but fallen angels have historically had a significantly higher weighting towards BB rated bonds than the broad market. The reason is simply that downgrades generally occur in the BB space and many (but not all) fallen angels typically remain at about BB. There’s an incentive among fallen angel issuers to regain investment grade status. A lot of investment grade companies were built around a high grade capital structure and that impacts the entire operations of a company – access to long-term and relatively cheap financing. There is also a higher propensity for credit rating upgrades among fallen angels as well.
Lastly, you can get pretty significant sector differences between fallen angels and the broad high yield market. Downgrades often impact many companies in the same sector around the same time, if caused by a macro event. That gets reflected in ANGL, which will typically go overweight a sector whose fundamentals have bottomed out and provide the potential for greater participation in a recovery. Similarly, it might avoid hot sectors where there may be increasing leverage, tight spreads and not a lot of downgrades, so ANGL is a contrarian strategy in many respects. Energy sector exposure is a great example of that. In 2014, when the price of oil was climbing and hit $100 per barrel, the sector was somewhat overheated with a lot of debt issuance and M&A, and ANGL was actually underweight by about 9% compared to the broad high yield market. Oil prices subsequently plunged to about $30 per barrel by early 2016, leading to massive downgrades in that sector. At that point ANGL had gone overweight energy by about 13%. The recovery in the sector was a significant contributor to outperformance over the next year or two. It’s a very opportunistic strategy in that regard, much like a distressed debt strategy in liquid format, done in a systematic way.
These three main characteristics—buying at deep discounts due to forced selling, higher quality and the contrarian sector exposure—really define fallen angels and have driven long term performance.
Q: The first quarter of 2022 was characterized by a hawkish Federal Reserve (Fed) and rising bond yields, impacting the entire spectrum of fixed income investments. How have fallen angels performed compared to broad high yield bonds to start 2022, and more broadly speaking, during periods of rising rates historically?
A: So far this year, fallen angels have underperformed broad high yield because of rising bond yields. It’s important to point out that fallen angels have a higher duration than the broad high yield market, currently about 6.1 vs 4.2.vii This is because fallen angels were previously investment grade. High yield issuers generally can’t issue beyond 10 years because of the riskier nature and the higher cost. Investment grade issuers typically lock in debt financing for 20 years or longer. When an investment grade issuer’s debt is downgraded, the maturity profile of their debt will typically be much longer than that of a high yield issuer.
Fixed income investors are certainly facing a challenge right now with rising rates. If you look at discrete periods of rising rates, fallen angels can certainly underperform, all else equal. However, over longer periods and market cycles, fallen angels have actually held up quite well in rising rate periods historically. For example, there have been nine years since 2003 (which is when ANGL’s index launched) where rates have risen significantly (100 basis point yields or a Fed hike). Fallen angels outperformed the broad market in seven out of nine of those years. Similarly, fallen angels outperformed the broad market in the last two Fed hiking cycles, from 2004 to 2006, and from 2015 to 2019.viii
These examples illustrate that although rising rates may have a negative impact on fallen angels like any other fixed income asset class, there are other factors that can help compensate for that. First, because these are high yield bonds, returns are generally more impacted by credit spread movements rather than rates, as opposed to lower yielding investment grade bonds, which are more rate sensitive. If rising rates are reflective of continued economic growth, you can have spread tightening, which is obviously beneficial. Spreads are below historical averages right now, which could limit tightening, but historically they’ve been negatively correlated with rates. Economic growth can also mean more credit rating upgrades and rising stars, and that can be beneficial to performance. We’ve certainly seen higher volatility in interest rates recently, and historically the higher quality of fallen angels can help provide a cushion in a selloff. And lastly, if conditions tighten up to the extent that growth slows and perhaps even induces a recession, keep in mind that downgrades are another source of outperformance for fallen angels because of that ability to buy bonds at deep discounts.
Overall, you have several diversified sources of return beyond just interest rates. Each can play a different role at different parts of a market cycle, including the different stages of an interest rate cycle. We often refer to ANGL as a “through the cycle” high yield strategy. There will always be periods of underperformance but through a market cycle and over the longer term, fallen angels have tended to outperform thanks to these drivers of return.
Q: With spreads at or near historic lows, are investors currently being compensated appropriately for owning high yield in portfolios?
A: That’s definitely a question we’ve gotten a lot over the past year or so. Spreads have widened somewhat year to date, but overall are still quite a bit tighter than they’ve been versus historical averages over 3, 5 or 10 years.
We need to view that through the context of current fundamentals. We’ve seen very strong economic growth and an extremely favorable credit environment over the past year or year and a half. Revenue and EBITDA are meaningfully above their pre-pandemic levels. Leverage has declined, debt service coverage ratios are at record highs and profit margins, overall, remain above historical averages. We also have greater Fed clarity on the future path of interest rates. All of these are positive for credit spreads, so current spread levels may seem apparently tight but perhaps not so much if viewed in that context. It’s unclear how much tighter they can go, but it’s also unclear what the catalyst will be for significant near-term widening, although we do expect increased volatility given the various risks in the market right now.
From an absolute return perspective, when spreads are very tight, it’s harder to make a strong case for high yield. But in a positive growth, positive credit environment where investors do need income, we think fallen angels can be attractive. Certainly on a relative basis, we think ANGL is an attractive option for a strategic allocation to high yield even in tighter spread environments. Fallen angels have actually outperformed broad high yield in tight spread environments, when spreads have been tighter than their historical average. In the five such periods since 2003, we’ve actually seen significant outperformance in these periods – on average by about 450bps over the broad high yield market benchmark.ix
Q: The ongoing geopolitical situation between Russia and Ukraine continues to agitate markets around the world. How can a portfolio of fallen angel bonds help maintain current income while moving up the credit quality spectrum?
A: The Russia-Ukraine crisis is clearly a risk for any riskier asset class, including high yield, and needs to be monitored closely for its impact broadly on credit spreads or risk appetite. There are a few elements of fallen angels that we believe can still allow investors to maintain a decent level of income while managing for risk, certainly as an attractive alternative to a broad high yield exposure.
First, recall that fallen angels are 90% BB rated, the higher quality end of the high yield spectrum. Now this is still high yield, so in the event of a market selloff and a spike in volatility, fallen angels shouldn’t be thought of as immune by any means. But BB’s can outperform lower rated bonds like CCCs when you have deep drawdowns, so the higher quality could be an appealing aspect in that type of market.
We’ve mentioned the longer duration of fallen angels, and that’s definitely been a headwind so far this year with rising rates. Ongoing geopolitical turmoil, to the extent it sparks any type of flight to quality, could benefit if we see rates compress.
And then the other point on fallen angels in this context relates to current sector positioning. The portfolio is currently overweight energy with about 30% of the portfolio in that sector, and reached this level following the massive downgrades we saw in 2020 with the onset of the pandemic. We saw large issuers like Occidental, for example, come into the index. Given where energy prices are, we believe many of these names could benefit. We’ve seen a few upgrades of fallen angel energy issuer back to investment grade, including most recently EQT, which has over $3B of debt and was about 2% of ANGL’s index when it exited.x If oil prices remain high, that’s credit positive for many of these other issuers in the portfolio.
Q: One other potential source of total return within fallen angel bonds comes from “rising stars” – that is, bonds that regain investment grade status. How have rising stars historically performed and what is the potential for rising stars in the portfolio as it stands today?
A: We think this is going to be the big story this year. It was a big story last year, but given the credit rating migration trends, which is reflective of a very favorable credit environment, we think that could continue.
And the reason that is important is that rising stars tend to strongly outperform the broader market prior to upgrade. In the 12 months prior to upgrade, rising stars have historically outperformed the broad market by nearly 8%.xi It’s kind of like the fallen angel effect in reverse. The market anticipates ratings actions and drives up the price of these bonds before the rating agencies actually take action. When you have a significant chunk of the portfolio being upgraded, that can drive meaningful outperformance.
The reason it’s important for fallen angel strategies like ANGL in particular is that fallen angels have historically had a higher tendency to be upgraded back to investment grade, versus the ascension rate among broad high yield issuers. There’s an incentive to regain investment grade status to get back to lower financing costs and longer term financing.
Historically fallen angels have a rate of rising stars that’s about twice that of the broad high yield benchmark. Last year was a higher than average ascension rate, and if our expectation for $200B to $250B of additional rising stars through 2023 materializes, we think it could be very meaningful this year and next. We noted EQT being upgraded this month, which was about 2% of the index. We also saw Kraft Heinz upgraded earlier in March, which was about 10% of the index and represents $18Bof upgraded debt –very significant.
Some clients have asked how that outlook might change given current risks which have emerged: how do Russia, inflation, the inversion of the yield curve, and rising rates impact forecasted growth and credit migration trends? All of these may pose risks to growth and have an impact on future upgrades. But the really interesting thing about a strategy like ANGL is that different drivers of return can kick in as the market environment changes. It’s a very dynamic strategy. If you have a growth slowdown or a recession, credit metrics may turn negative and you’ll probably see downgrades rather than upgrades. That’s a good thing for ANGL. Outperformance has tended to correlate with the level of downgrades, and the more downgrades you have, the deeper the discounts will likely be. That’s exactly what happened in 2020. So ANGL is really an all-weather high yield strategy in that regard, whether we’re talking about rising stars in a positive credit environment or fallen angels in a deteriorating environment.
Originally published by VanEck on April 11, 2022.
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iSource: Morningstar, Inc.© Data as of 3/31/2022. The information contained herein: (1) is proprietary to Morningstar; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. The peer group chart presents trailing total return percentile rankings against the Morningstar Open End Funds – U.S. – High Yield Bond category, which comprised 705 funds as of 3/31/2022.
ii Source: Morningstar. Fallen Angel U.S. High Yield represented by the ICE US Fallen Angel High Yield 10% Constrained Index (H0CF) and Broad U.S. High Yield by ICE BofA US High Yield Index (H0A0).
iii Source: ICE Data Indices as of 3/31/2022. Fallen Angel U.S. High Yield represented by the ICE US Fallen Angel High Yield 10% Constrained Index (H0CF) and Broad U.S. High Yield by ICE BofA US High Yield Index (H0A0).
v Source: FactSet.
vi Source: ICE Data Indices as of 3/31/2022. Fallen Angel U.S. High Yield represented by the ICE US Fallen Angel High Yield 10% Constrained Index (H0CF) and Broad U.S. High Yield by ICE BofA US High Yield Index (H0A0).
viii Source: FactSet. Data as of 3/31/2021. A significant rise in interest rates is defined as a 100 basis point increase in the 5-year Treasury yield or an increase in the Federal Funds target interest rate in a given calendar year. Current data may differ from data quoted. Past performance is no guarantee of future results; VanEck Fallen Angel High Yield Bond ETF commenced on 4/10/2012. An investor cannot invest directly in an index. The results assume that no cash was added to or assets withdrawn from the Index. Index returns do not represent Fund returns. Fallen Angel U.S. High Yield is represented by the ICE US Fallen Angel High Yield 10% Constrained Index (H0CF) and the Broad U.S. High Yield by ICE BofA High Yield Index (H0A0).
ix Source: ICE. Past performance is not indicative of future results. Fallen Angel U.S. High Yield represented by the ICE US Fallen Angel High Yield 10% Constrained Index (H0CF) and Broad U.S. High Yield by ICE BofA High Yield Index (H0A0).
x Source: ICE Data Indices as of 3/31/2022.
xi Source: ICE Data Services, as of 3/31/2022. Rising star data refers to the index data on and prior to February 28, 2020 that reflects that of the ICE BofAUS Fallen Angel High Yield Index (H0FA). From February 28, 2020 forward, the index data reflects that of the Fund’s underlying index, the ICE US Fallen Angel High Yield 10% Constrained Index (H0CF). Index history which includes periods prior to February 28, 2020 links H0FA and H0CF and is not intended for third party use. It is not possible to invest directly in an index. The Broad US High Yield is represented by the ICE BofA US High Yield Bond Index. Past performance is no guarantee of future results. Index performance is not illustrative of fund performance.
A fallen angel bond is a bond that was initially given an investment-grade rating but has since been reduced to junk bond status.
High yield bonds may be subject to greater risk of loss of income and principal and are likely to be more sensitive to adverse economic changes than higher rated securities.
A rising star is a high yield bond that is upgraded to investment grade.
Past performance is not indicative of future results. Performance current to the most recent month end is available by clicking here.
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ICE BofAML US High Yield Index (H0A0, “Broad HY Index”), formerly known as BofA Merrill Lynch US High Yield Index prior to 10/23/2017, is comprised of below-investment grade corporate bonds (based on an average of various rating agencies) denominated in U.S. dollars.
ICE US Fallen Angel High Yield 10% Constrained Index (H0CF, Index) is a subset of the ICE BofA US High Yield Index and includes securities that were rated investment grade at time of issuance.
Fallen Angel U.S. High Yield index data on and prior to February 28, 2020 reflects that of the ICE BofA US Fallen Angel High Yield Index (H0FA). From February 28, 2020 forward, the Fallen Angel U.S. High Yield index data reflects that of the Fund’s underlying index, the ICE US Fallen Angel High Yield 10% Constrained Index (H0CF). Fallen Angel U.S. High Yield index data history which includes periods prior to February 28, 2020 links H0FA and H0CF and is not intended for third party use.
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