uploads/2017/05/credit-comp-1.png

Insights into the Credit Quality of Fallen Angel Bonds

By

Updated

VanEck 

Given these uncertainties, high yield bond investors may want to ratchet up the credit quality of their portfolios. Fallen angels can be a source of higher quality high yield for investors, given about 77% of the universe was concentrated in BB-rated bonds (just one ratings notch below investment grade) as of April 30, 2017.[2.Composite ratings are based on the simple averages of ratings from Moody’s, S&P, and Fitch. This composite is not intended to be a credit opinion. Investment grade bonds are rated AAA to BBB (high to medium credit quality). Below-investment grade bonds have credit ratings of BB, B, and CCC, and have lower credit quality.] This compares to the broader high yield bond universe’s 48% concentration in BB-rated bonds.

Furthermore, this higher average credit quality has been accompanied by more attractive rising star and default rates, historically. Fallen angel bonds have boasted higher “rising star” success than original-issue high yield bonds―meaning more fallen angels have risen back up to investment grade status (5.3% versus 2.6% averaged annually).[3.Since inception of BofA Merrill Lynch US Fallen Angel High Yield Index on 12/31/2003.] Finally, fallen angel bonds have experienced lower average default rates versus original-issue high yield bonds (3.5% versus 4.5%), making them a potentially attractive high yield option from a credit risk perspective.[4.Source: Altman, Edward I. and Brenda J. Kuehne. “Defaults and Returns in the High-Yield Bond and Distressed Debt Market: The Year 2016 in Review and Outlook”. February 2017. NYU Salomon Center. Data as of December 31, 2016. **Issuer based.]

 

Market Realist

Credit quality

Fallen angel bonds’ (ANGL) highest composition of BB-grade bonds puts them ahead of other high-yield bonds with respect to credit quality, as you can see in the chart below. The importance of credit quality cannot be overemphasized in today’s rapidly evolving global scenario.

We can also infer from this factor that emerging market bond prices (EMLC) and international corporate bond prices (IBND) have recovered since the US election results in November 2016, as the stock price movement chart (see Part 1 of this series).

The statistics of performance, universe concentration, lower default rate, and recovery to investment-grade status clearly hinge on fallen angel bonds.

VanEck’s Fran Rodilosso has endorsed high-yield bonds (JNK) (BKLN), given US President Donald Trump’s probable approach to improving economic fundamentals, rising inflation, tightening credit spreads, and the strengthening US dollar (UUP). Fallen angel bonds not only offer higher returns than traditional high-yield investment-grade bonds and equity strategies but also come with low volatility, as compared to the equity strategies that we discussed in the first part of this series.

Fallen angel bonds have now seen a one-year annualized growth rate in net asset value of ~17% and have assets under management of ~$826 million.

Fed rate hike consequences

If the Fed (US Federal Reserve) carries out its rate hike projection during the remainder of 2017, it will likely have an inverse effect on bond prices, because a hike in the fed rate should lead to a slump in the bond yield. Since bond prices (BND) are inversely related to bond yields, we’ll also likely see an obvious drop, as higher interest rates among new bonds render the older bonds less popular.

Remember, the US is a major issuer of bonds, and investors could see a lot of activity stemming from Trump’s ambitious infrastructure (IGF) (INXX) spending plans—should they be enacted.

More From Market Realist