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Fallen Angel Bonds: A Slice of Investor Heaven?

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Noted for a history of equity-like returns and less sensitivity to rising interest rates than investment grade bonds, high yield bonds have become known as a distinct asset class warranting a strategic allocation in many fixed income portfolios. Fallen angel bonds, high yield bonds that were originally investment grade issues, call for further distinction for an embedded value proposition that is not common to all of high yield. Fallen angels make up about 15% of the broad U.S. high yield bond market.

Source: FactSet. Data as of March 31, 2016. Historical performance is not indicative of future results; current data may differ from data quoted. Indexes are unmanaged and are not securities in which an investment can be made.

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For 9 out of the last 12 calendar years, fallen angel high yield bonds[1. BofA Merrill Lynch US Fallen Angel High Yield (H0FA) is a subset of the BofA Merrill Lynch US High Yield Index (H0A0), including securities that were rated investment grade at time of issuance. BofA Merrill Lynch US Original Issue High Yield (H0HY) is a subset of the BofA Merrill Lynch US High Yield Index, including securities that were not rated investment grade at the time of issuance.] have outperformed the broad U.S. high yield bond market[2. Barclays US High Yield Very Liquid Index is the market of USD-denominated, non-investment grade, fixed-rate, taxable corporate bonds. Qualifying issues must have been issued within the past three years, have a USD 600 million minimum amount outstanding and include only the largest issue from each issuer. Morningstar High-Yield Bond average category is comprised of open-end mutual funds with an investment objective to seek returns via significant exposure to low quality bonds; those that are either unrated or rated by a major agency as BB or lower.], including original-issue high yield bonds. Year to date, as of March 31, 2016, fallen angels have outperformed the broad high yield bond market by 287 basis points: 6.54% vs. 3.67%.

Relative to original-issue high yield bonds, fallen angel bond outperformance can be attributed to a variety of historical trends; including valuation after forced selling by investment grade investors, franchise or brand value generally associated with the larger issuers, and a higher propensity to seek to and eventually regain investment grade status.

Market Realist – High-yield bond funds (HYG) (JNK) regained some lost favor this year. This is evident by the recent uptick in assets under management and rising volumes of junk bond ETFs. With low yields across the globe and growing turbulence in equity markets (SPY) (VTI), yield-starved fixed income (BND) investors are turning to the high-yield bond space for income. We think that fallen angel bonds could be an extremely attractive value proposition for investors for several reasons:

  • As you can see in the above graph, fallen angel bonds tend to outperform high-yield bond indices. The BofA Merrill Lynch US Fallen Angel High Yield Index ended 1Q16 up by 6.5%. The BofA Merrill Lynch US High Yield Index rose by 3.3% during the period. On a total return basis, the fallen angel subsector is up by 9.4% YTD (year-to-date). Currently, the broader high-yield sector is up 5.3% YTD.
  • The credit ratings for fallen angel bonds tend to remain stable once they have fallen from their investment grade status. There’s a lower possibility of a downgrade in the future.
  • Since fallen angel bonds tend to deleverage after downgrades, the possibility of an upgrade in ratings is more likely than a typical high-yield bond fund. Fallen angel bonds tend to be larger than average companies with original junk bond status. They have more resources and knowledge to improve their credit quality.
  • Fallen angel bonds tend to provide quality to a junk bond portfolio. According to analysis from Market Watch, 88% of all European fallen angel bonds as of December 31, 2015, are rated BB. Only 4% saw their rating fall to CCC+ and below. The ten-year arithmetic average of the 12-month credit default rates for fallen angel bonds is estimated to be 3.58. The figure is estimated to be 4.48 for original issue speculative grade bonds (Source: VanEck Vectors).

Read on to the next part of the series to understand more about why investing in the VanEck Vector Fallen Angel ETF (ANGL) could be a good idea for high-yield investors.

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