By William Sokol, Senior ETF Product Manager
The fallout from recent market volatility included a series of corporate bond credit downgrades that expanded the fallen angel high yield bond universe. Fallen angel bonds are unique in that they are corporate bonds that were originally issued as investment grade before being downgraded to junk status. As interest rates remain low and spreads tighten, we believe fallen angel bonds may present an attractive opportunity for investors.
Welcoming New Fallen Angel Bonds—at Deep Discounts
The fallen angel market has welcomed several big names this year, including Kraft, Ford, and Occidental Petroleum. After the most recent entrants at the end of May, the year to date total fallen angel market value reached $199B.1 Historically, strong returns and outperformance vs. the broad high yield market have followed years where there has been high volume of fallen angels.
In this year’s fallen angel wave, we have seen a familiar technical pattern: investment grade managers selling bonds that were downgraded to junk and driving down the bond’s price. This is when the contrarian approach of fallen angel investing comes into play: buying bonds that other market participants are selling, usually at high discounts.
For example, bonds of ArcelorMittal (Basic Industry/Steel Producer) and Services Property Trust (REIT), which became fallen angels in May, experienced an average price return of -12.44% over the six months prior to downgrade. 2 Year to date, fallen angels have entered the Fallen Angel U.S. High Yield Index3 at average discounts more than twice as large as the average discount for the past 10 years. Energy sector bonds have entered at discounts even higher than the overall average for fallen angels this year.
|Past 10 Years*||YTD Fallen Angels||May Fallen Angels||June Fallen Angels||YTD Energy Fallen Angels|
|Average 6-month Price Return Prior to Entering Index||-6.90%||-18.01%||-22.15%||-12.44%||-24.53%|
|Average Price When Entering Index||92.01||85.02||80.47||91.19||77.82|
Source: Factset, ICE. Data as of 5/31/2020.
*Data from 12/31/2009-12/31/2019
Lower Credit Risk Relative to Broad High Yield
A majority of the bonds that become fallen angels end up in the BB bucket, which means less credit risk for investors compared to the broad high yield market. After the fallen angel index welcomed a significant number of new issuers in April-month-end, it had 92% concentration to BB. In comparison, only 56% of the broad U.S. high yield market4 were rated BB. In May-month-end, the two new fallen angels were both rated BB, which kept the index’s BB exposure steady at 92% vs 55% of the broad U.S. high yield market.
Higher Credit Quality Relative to Broad High Yield
Outperformance Through Market Cycles
Investment-grade issuers tend to have lower risk, lower funding costs, and better access to capital markets, and therefore tend to have bonds with longer maturities, which results in longer duration. As a result, fallen angels typically exhibit higher duration compared to original issue high yield bonds.
Although there has been a small increase in duration year to date from 5.9 on 12/31/2019 to 6.3 as of 5/31/2020 as interest rates have declined, the substantial fallen angel volume has not led to a drastically different duration profile for the fallen angel index.
Further, when interest rates have gone up historically, fallen angel bonds have outperformed the broad high yield and the short duration high yield market5 in most years, despite the longer duration, based on returns for the Fallen Angel U.S. High Yield Index, the ICE BofA US High Yield Index and the ICE BofA 0-3 Year US High Yield Index.
Historical Outperformance vs. Broad High Yield and Short Duration High Yield
For example, from 2015-2018 period, interest rates rose from 0.75% in December 2015 to 3% in December 2018 following a series of rate hikes, while credit spreads overall were nearly unchanged. Although fallen angels underperformed by an average of 40 basis points in the months in which the Federal Reserve raised interest rates, fallen angels as represented by the Fallen Angel U.S. High Yield Index outperformed over the entire period, returning 6.40% (annualized) while short high yield as represented by the ICE BofA 0-3 Year US High Yield Index only returned 4.98% (annualized).
What explains this? Often, credit spreads tighten in higher growth environments, while interest rates rise. This will generally benefit longer duration credit-sensitive bonds. However, in this period, the outperformance of fallen angels was primarily driven by an overweight to energy and basic industry sector bonds. These sectors, which experienced a strong price recovery following a selloff and rating downgrades in 2014 and 2015, drove fallen angel’s strong outperformance over this period due to the impact of buying deeply discounted bonds.
Fallen Angels vs. Short Duration High Yield in a Rising Rate Environment – 2015-2018
Source: ICE and St Louis Fed.
We anticipate 2020 to be a record year for fallen angel bond volume. Our forecast is for $250B – $300B of fallen angel volume this year. For investors, we believe this increase in volume and the discounts seen in new entrants, along with the current low interest rate environment—expected to remain in place until 2022—and continued tightening of spreads make this an attractive time to invest in fallen angel high yield bonds.
1 Source: ICE
2 Source: ICE
3 Fallen angel index refers to the ICE US Fallen Angel High Yield 10% Constrained Index (H0CF, Index)
4 Broad U.S. High Yield refers to the ICE BofA High Yield Index (H0A0)
5 Refers to ICE BofA 0-3 Year US High Yield Index (HSA0)
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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.
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