Paul Benson and Manuel Hayes
We believe “fallen angels” could be an underappreciated opportunity. It may be best to think of them as a compelling risk asset class in their own right.
Fallen angels are former investment-grade companies that have been downgraded to high yield. They tend to have higher credit ratings than other high yield issuers, with 80% holding the highest sub-investment-grade designation (Figure 1).
Yet, fallen angels have outperformed the high yield market by 2% per year on a total return basis since the fallen angels index launched in 2005, with only modestly higher volatility. They also currently offer similar yields to high-yield bonds (Figure 2).
Fallen angels have had higher volatility than high-yield bonds partly due to their higher average duration exposure as well as pricing disruptions relating to downgrades and upgrades.
When issuers get downgraded to high yield they suffer upon the downgrade and from “forced selling” at month=end from many passive investment-grade accounts that can no longer hold them. On average this period has historically resulted in significant excess widening ahead of entry into high yield (Figure 3).
As fallen angel bonds enter the high-yield universe they enter at potentially attractive levels. Historically the bonds’ spreads have subsequently tightened relative to peers (Figure 3).
As such, downgrades are often treated as good news by fallen angels investors.
Upgrades are good news too. So-called “rising stars” (companies upgraded from high yield to investment grade) benefit holders as the bonds’ spreads tend to tighten when upgraded due to improving credit metrics and “forced buying” from investment-grade accounts. Our analysis shows that rising stars have been more than twice as likely to be former fallen angels than other high-yield issuers.
We project $30 billion to $50 billion of new fallen angels over the next 12 months as the economy moderates. The share of BBB- bonds on negative outlook (for a downgrade to high yield) is 5.7%, up from just 2.8% in February and the highest since the pandemic according to analysis from BofA Global Research published in May.
At present, we expect to see new fallen angels across multiple sectors such as communications and capital goods, technology, transport and REITS. The market for BBB- bonds (which are just one notch above high yield) is currently $700 billion, according to Bloomberg. It contains roughly $200 billion of bonds currently trading with wider credit spreads than their comparable BB rated peers, based on our analysis. In our view, this indicates that markets are pricing in downgrade risks in these names.
Should these downgrades materialize, it would broaden and deepen the fallen angel market and potentially plant the seeds for future “rising stars.” Once downgraded to high yield, fallen angels are typically incentivized to shore up their balance sheets, in the hopes of reattaining investment-grade status, to manage their borrowing costs.
The downside is that more downgrades also imply higher defaults as the economy continues to moderate. We do indeed expect defaults to creep up over the next year. Nonetheless, we only expect the rise in defaults to rise closer to historical averages (which we calculate to be 1.8% per year for fallen angels and 2.4% per year for high yield from 2005 to 2023).
Another reason that defaults could potentially be contained in high-yield bond markets is that leveraged buyouts (or LBOs) are increasingly being financed in private credit markets. Since 2022, 80% to 95% of LBOs have been financed in private markets instead of in the bond markets, vs. 40% to 50% prior according to data from Barclays Capital. As such, this is helping reduce the amount of leveraged borrowers in the bond markets.
Most traditional passive and active managers may struggle to invest in fallen angels as a standalone allocation. As such, relatively few strategies exist that specifically target fallen angels.
Liquidity and trading frictions are the main hurdle. When trading bonds one at a time over-the-counter (which is the traditional method), fallen angel bid-ask spreads are typically 90 basis points to 100 basis points.
In 2012 we developed a credit portfolio trading approach that we use to exploit liquidity within from the ETF ecosystem and reach harder-to-access bonds. We have found this approach to be cost-efficient and it also allows us to trade at high volumes.
We are at the start of the rate cutting cycle, with rate cuts now on the agenda for the foreseeable future. We believe this could be a positive environment for fixed income.
Fallen angels could be worth considering as a choice risk asset within fixed income, given historically high yields, relatively high credit ratings and the potential for favorable volatility relating to ratings migration.
Paul Benson is head of systematic fixed income and Manuel Hayes is a senior portfolio manager at Insight Investment. They are based in San Francisco. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I’s editorial team.
