Credit spreads, which gauge differences in yield between two bonds with the same maturities and different credit quality, are currently surprisingly tight given rising interest rates. That could be a sign opportunity beckons with some corners of the high-yield bond market. One way of capitalizing on that scenario is with the VanEck Fallen Angel High Yield Bond ETF (NASDAQ: ANGL).
ANGL, which tracks the ICE US Fallen Angel High Yield 10% Constrained Index, holds bonds that were born as investment-grade fare that were later downgraded to junk status.
In other words, ANGL has a better quality profile than a standard junk bond ETF. That’s a pertinent trait today because quality may be one of the reasons credit spreads are tighter than expected.
“There are some possible explanations. First, the quality of the high-yield corporate market is noticeably better than just prior to the pandemic and noticeably different than 10 years ago. Another possible explanation is morale hazard. For the first time, the Fed intervened in the corporate bond market during the pandemic and investors may be assuming that the central bank will do it again if there are financial stability issues or a recession,” according to Moody’s Investors Service.
If banks commence a round of tighter lending standards, thereby making credit less accessible, corporate bond spreads could widen. That might not be ideal for standard junk bonds, but investors still need income, indicating that ANGL could be a viable option in an environment where credit spreads could widen with little advanced warning.
“Spreads should widen soon as banks continue to tighten lending standards. The correlation coefficient between the net percentage of banks tightening lending standards on commercial and industrial loans and the U.S. high-yield corporate bond spread is 0.73,” added Moody’s. “With banks tightening the screws, odds are high that high-yield corporate bond spreads will resume widening.”
The $2.8 billion ANGL offers other advantages. For example, more than 27% of the ETF’s holdings are issued by energy companies. Not only are oil prices high, but the industry is home to many companies that have increasingly strong balance sheets and some that are generating ample amounts of free cash flow, indicating solid abilities to service debt obligations, even in a recession. That’s relevant in any environment, especially one in which a recession could be nearing.
“The share of banks tightening lending standards on C&I loans breached the threshold that has been consistent with a recession in the past. We doubt recession fears will vanish soon and this should also boost high-yield corporate bond spreads,” concluded Moody’s.
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