LO Funds
Fallen Angels Recovery

Fixed Income Market overview

January rang in the new year with some uptick in macro volatility, as start of year flows and positioning coincided with the return of Donald Trump to the White House. That said, fixed income ultimately posted strong returns for the month, led by high yield spread compression particularly in the US, while Euro duration was the laggard. From a sectoral perspective, the main exception to the spread rally was in Euro capital goods and basic industry, likely stemming from tariff concerns. Early moves in markets to start the year largely followed the year end sentiment, with rates, particularly term premia, moving higher as concerns of fiscal profligacy lingered and uncertainty around the new Trump administration's international policy came to the forefront. The focus leading into Trump's Jan 20th inauguration focused on the prospect of sweeping trade tariffs, as markets wrestled to price the growth and inflationary impacts of such a move.However, rates reversed their global rise mid-month as rumours appeared to point towards less appetite than feared towards imminent tariffs from Trump's team. News flow for the rest of the month was erratic around this front, but fixed income markets ultimately looked through the noise and pricing as if they're expected to be specifically targeted or used more from a negotiating perspective, rather than a more damaging blanket implementation as alluded to in the build up to inauguration.Macro data itself continued its trend of gently declining inflation as lagged components of CPI normalize, whilst growth and labour markets continue robustly in the US but less so in the Eurozone. The continuation of this trend allowed for markets to find some footing after the aggressive rate sell off to start the year and was further supported by central bank meetings in line with expectations. The Fed paused the cutting cycle, as flagged at December's meeting, citing the need for more data on the inflation outlook, whilst the ECB cut again in the face of a drab growth picture.An outlier in the picture, and a trend that could have growing implications this year, was another 25bp hike from the Bank of Japan following a sharp pick up in headline CPI for December. This was the first move since their hike in the summer triggered a market rout as carry trades unwound. While market reaction was contained this time, with less than 35bps of hikes priced in for the year, further upside expectations for Japanese monetary policy is a trend to watch and could threaten another carry unwind if repricing happens suddenly. Another noteworthy development in the month came in the emergence of a perceived disruptor in the AI space out of China. The Chinese star-up named 'Deepseek' was flagged as offering a competitive product against more established models, but at a dramatically lower cost and being entirely open source. Due to its direct impact on mega-cap tech stocks in the US, headline moves in US equity markets were sizable. However, wider impacts were quickly retraced, with reports suggesting that the model itself is largely trained using competitor products, limiting the actual jump in innovation that was first expected. Nevertheless, in reality, the newsflow is only material for a handful of tech stocks, so from a credit perspective, we see little downside from such a development.All in all, we tend to try and look through start of year volatility or trends as large-scale repositioning can drive moves that warrant fading rather than putting weight behind. That said, rates and FX markets took the brunt of this start of year volatility, whilst credit volatility remained subdued and continued its impressive streak of resilience against macro uncertainty despite spreads being at historical tights. We see this as a sign of continued positive sentiment towards the strength of corporate balance sheets so continue to like accessing extra carry through spreads in quality companies. The rate repricing also opened interesting absolute and relative value entry points in duration, with European rates selling off in sympathy with US rates despite less concerning inflation outlooks. We continue to see duration tactically as an opportunity for mark to market performance.

Portfolio activity

There was a single new Fallen Angel in January with no issuers leaving the Fallen Angel universe.Auto-parts supplier APTV announced a plan to spin off its Electrical Distribution System into a separate company by Mar-26. As a result Fitch placed its BBB ratings on review for downgrade. It also downgraded the subordinated bonds by one notch to high yield to more closely align the rating with similar instruments; effectively acknowledging the previous rating was incorrect. Both Moody's and S&P were unchanged. We expect the bonds to stay at APTV and APTV to maintain its IG rating which will support a stable BB or BB+ rating at the subordinated bond making it an eligible investment.We also took advantage of the new issue market to add BB-rated issuers such as:- ContourGlobal operates a diversified portfolio (189 plants across 20 countries) of renewable and thermal generation assets with a solid client base of long-term, contractually supported, investment grade off-takers. It is transitioning to renewable energy and will have phased out its remaining coal powered plants by 2027. Mgmt have made a clear commitment to maintaining the BB rating which we believe is achievable.Aareal Bank is German-based commercial real estate lender that has been actively managing its US office exposure and disposing of non-performing loans. The bank has a high capital buffer with a CET1 ratio of 19.3% at Bank level, 16.7% at Atlantic Group level, providing large MDA buffers of 990bps and 720bps to regulatory requirements. This will be further bolstered by a EUR 2bn capital gain from the sale of its Aareon business, though most proceeds are expected to be distributed to shareholders over time.

Performance and characteristics

The fallen angel strategy is a high quality high yield strategy with an average rating of BB.The strategy modestly under-performed the high yield index in January as our holdings in the telecom sector (Telecom Italia, Eutelsat, Vodafone) all under-performed. We believe this was driven by unwarranted investor concerns over the competitive threat in the satellite space from Elon Musk's Starlink. Outlook: The recovery in the real estate sector since the end of 2023 has now largely run its course. We do not discount one or two more Fallen Angels to come from this source but it is no longer a sector in crisis. We are seeing some weakness within the consumer cyclical and automotive sectors but expect new Fallen Angel supply in 2025 to be driven largely by idiosyncratic events rather than sector specific weakness. We do not currently expect many new Fallen Anegls linked to US tariff's but we continue to monitor developments here closely.