The beautiful inefficiency of fallen angels

Fallen angels – corporate bonds which drop from an investment grade rating into the high yield universe – create technical dislocations in the fixed income market that can throw up opportunities to generate alpha upon completion, according to Insight Investment^[1] senior product specialist Syed Zamil.

When a company’s credit rating changes from BBB to BB it makes a significant move out of investment grade and into high yield territory. The transition of these bonds, known as fallen angels, can force certain holders such as index funds and insurance companies to sell, resulting in technical dislocations and market “disorder ” that can offer opportunities, says Zamil.

“At the time of downgrade these bonds face so much selling pressure but after that formal downgrade, the pressure subsides and these bonds tend to recover strongly over the next 12 to 24 months,” Zamil says.

Beautifully twisted

Zamil argues this dislocation creates opportunities for total returns as well as alpha, pointing to the 10% annual return of the Bloomberg Barclays Fallen Angel 3% Cap index between 2005 and 2021, compared with the MSCI World index’s 8%^[2]. He adds the fallen angel index has also carried lower risk over the period in terms of standard deviation at 10%, compared with 15% for the MSCI World^[3].

“Like our kids we never say we have a favourite, but we do have a favourite investment and it’s fallen angels – which can offer a compelling risk-return profile,” adds Zamil.

“Our lead portfolio manager often refers to the fallen angel sector as a beautifully inefficient market as there are so many market dislocations that not only does it allow for high total returns, but also inspired opportunities for alpha.”

Zamil also notes how spreads tend to widen before the formal downgrade occurs and tighten afterwards. Prior to downgrade, the bond is still investment grade status and so fallen angel investors avoid the spread widening but when the bond moves into high yield, becoming a fallen angel, investors participate in the upside from spread tightening.

Low default rates

Elsewhere, Zamil is keen to dispel a common misconception that fallen angels, and high yield corporates generally, have high default rates, as highlighted by certain ratings agency methodologies. These ratings tend to include a broader range of bonds than the high yield index, including short-dated issues, with a maturity of less than one year, and floating rate bonds. They also equal weight the constituents, so small bonds get the same weight as large bonds which, Zamil thinks, creates a misleading number.

He notes the annual average default of the US high yield corporate index^[4] between January 2005 and December 2021 is 1.52%, whereas the annual default in the US fallen angels index^[5] has been just 0.62%. Moody’s US Speculative Grade, however, puts the annual default rate over the period higher, at 4.06%^[6].

“The key takeaway here is the likelihood of default with fallen angels is quite low,” adds Zamil.

He also observes how 90% of the fallen angel index is comprised of BB-rated bonds versus 55% for the US high yield index ^[7]. “So, you are getting the safest bonds in fallen angels and the default rate has been quite low,” he reaffirms.

Rising stars

The fallen angel index also has double the exposure to rising stars – bonds that get upgraded from high yield to investment grade status – than the US high yield corporate index, says Zamil. He notes the fallen angel index has 9.95% of rising stars compared with 4.94% for the US high yield corporate index^[8].

“Fallen angel bonds have tasted the sweet success of being an investment grade bond, paying lower rates etc, and when they get downgraded, they effectively fight very hard to re-gain that investment grade status,” he explains.

“If you look at some of the biggest names in the fallen angel index today, you would be surprised to find its companies whose bonds are not really high yield, but something has happened temporarily, they’ve cleaned up their act and we think they are going to get upgraded pretty soon.”

Notes

^[1]Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited (BNYMIM EMEA), BNY Mellon Fund Management (Luxembourg) S.A. (BNY MFML) or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and services entered into by clients with BNYMIM EMEA, BNY MFML or the BNY Mellon funds.

^[2] Insight, Bloomberg
^[3] Ibid
^[4] Bloomberg Barclays US Corporate High Yield Index, as at 31 December 2021
^[5]  Bloomberg Barclays Fallen Angel 3% Cap index, as at 31 December 2021
^[6] Bloomberg, Moody’s Investor Services
^[7] Bloomberg composite ratings
^[8] Bloomberg

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