Are fallen angels the better part of high yield?


From a bond investor’s point of view, does the meaning of “speculative grade” remain the same no matter how the bonds got there? Or does the path matter? One certainty is that every credit story is unique and full of nuances, but these questions might be valuable to ask when looking at diversified portfolios of high-yielding credits.

The performance of fallen angel high-yield bonds is something we were curious about. Thirty years ago, most high-yield bonds were what are now called fallen angels — once investment-grade issues that were downgraded to speculative grade. The leveraged finance industry has changed everything. Today, the majority of the high-yield universe is populated by bonds that were issued originally as subinvestment-grade debt.

Fallen angels issuers, when compared with most other high-yield borrowers, have tended to be typically larger, more mature companies with well-known brand names and/or significant market share (i.e. Ford, Sprint, Weyerhaeuser, El Paso and J.C. Penney). We looked at the average equity market capitalizations of fallen angel issuers vs. all high-yield issuers included in the Bank of America Merrill Lynch (BAML) high-yield debt indexes and found that the average equity market capitalization of the fallen angels was $18.5 billion, vs. $5.2 billion for the broader index as of May 10.

For fallen angels as a catego ry, the returns appear to have been favorable in comparison with other high-yield subcategories. Over the last five-year and nine-year periods ended May 16, 2012, the BofA Merrill Lynch U.S. Fallen Angel High Yield index has generated annualized total returns of 9.3% and 11.37%, respectively. The BofA Merrill Lynch U.S. High Yield Master II Index has returned 7.63% and 9.70% annually over those same periods. The annualized outperformance of the fallen angel index is 1.66% annually over 5 years and 1.67% annually since the fallen angel index’s inception nine years ago. The fallen angel index was indeed more volatile over these two periods (8.63%/6.6% vs. 6.73%/5.14% for the broader high-yield index).

There are numerous possible other explanations for the higher return numbers. Can the act of buying fallen angels be viewed as more of a contrarian or “buying after the news” strategy vs. buying high yield in general? What we know is that the fall from investment-grade to subinvestment-grade status has forced some institutional investment-grade investors, by mandate, to exit positions in the bonds. We also know that by the time the downgrade occurs, in most cases, the news has been well anticipated by the market. The exceptions have tended to be cases of fraud or extreme market distress such as Enron, WorldCom and Lehman.

According to BAML, the biggest downward movement in bond prices indeed takes place during the month prior to a downgrade, when the bank says bonds tend to underperform both BB and BBB indices by about 100 basis points. Anticipatory and forced selling has driven prices down to “bargain” levels in some cases. Fallen angel bonds are eligible to enter the above-mentioned BAML index the month following the downgrade. These dynamics may explain some of the fallen angel index’s historical outperformance of broader high-yield indexes. Based on the index rules, in June, we would expect Nokia bonds to enter the index. They have traded down 15-20 points since early March and were ultimately downgraded by Standard & Poor’s on April 27. Nokia’s equity market capitalization is presently around $10.5 billion.

Another potential boost from a credit perspective is that the focus of management for a fallen angel issuer might naturally be to regain investment-grade status. In such instances, a lower cost of funding may be factored into their business plan; such may not be the case with some high-yield issuers. In some ways, fallen angel issuers do have a head start. Their borrowings have historically tended to be longer term and their historical ability to access capital has been more flexible. For instance, the average modified duration of the BofA Merrill Lynch U.S. Fallen Angel High Yield index was 5.59 vs. 3.92 for the BofA Merrill Lynch U.S. High Yield Master II index (as of April 30).

Fallen angels may have experienced downgrades for a variety of reasons. They might have pursued an aggressive mercer and acquisition path. Their business model might have become outdated. They might have lost market share to a lower cost competitor. There might have been fraud. Their assets might have become impaired due to external forces beyond their control.

Some fallen angels truly have been sinners in the liability management sense and they have not recovered their investment-grade rating. Some fallen angels have lost all virtue and defaulted. (Historically when they have, it has been within six months to two years.) The ratio of ascension to investment grade for fallen angel issuers historically has outweighed, it seems, the number of defaults. According to Moody’s, from 1982 to 2011, 32% of all fallen angels ultimately migrated back to investment grade. The same study also shows that the rate of default during this period has been lower historically for fallen angels than for the high-yield market as a whole. According to a study by Edward Altman, the Max L. Heine Professor of Finance at New York University's Stern School of Business, fallen angels experienced annual default rates of 3.80%.

Now is a good time to mention that past results are not a reliable indication of future performance. A static comparison of the indexes currently, however, might also explain why some investors are interested in the fallen angel story. As of April 30, the average yield-to-worst of the BofA Merrill Lynch U.S. Fallen Angel High Yield index was 7.33%, vs. 7.08% for the BofA Merrill Lynch U.S. High Yield Master II index. The yield gap can be explained largely by the duration difference between the two indexes. In fact, the option-adjusted spread comparison was nearly a wash: 604 basis points vs. 602 basis points for the general U.S. high yield index. Interestingly, though, the “average quality” by BAML’s measure is a notch apart: B1 for high yield and BB3 for fallen angels.

How do fallen angels fit in a portfolio from the perspective of diversification? The correlation of BAML’s fallen angel index with its high-yield master index is high, at 0.93 over five-year and nine-year periods. The fallen angel index, however, shows a slightly lower correlation with equities (0.72 and 0.69 correlation with the S&P 500 over the last five- and nine-year periods vs. 0.77 and 0.74 for the BAML general U.S. high-yield index with the S&P 500). Both indexes show a low correlation with the Barclays U.S. Aggregate index over a five-year period, though the fallen angel index correlation comes in at 0.28 vs. 0.25 for the broader high-yield index (0.29 vs. 0.25 over the nine-year period).

Fran Rodilosso is a portfolio manager of Market Vectors ETFs at Van Eck Global.