fixed income
Fallen angels: beyond the downgrade
The dynamics of fallen angels make for compelling risk-adjusted returns but avoiding falling knives is paramount to maximise value for investors. From performance drivers to the supply outlook, we explore how active management can ensure we capitalise on a bond’s fall from investment grade.
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Need to know
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When a downgrade opens doors
A bond being downgraded to junk might be seen as a lost cause. Yet what if that downgrade also unleashed pricing dislocations that opened up wide-ranging opportunities: far from clipping the wings of a bond, it instead fuelled its outperformance relative to peers? Join us in exploring the potential of fallen angels, where our approach seeks to turn a bond’s downgrade to an investor’s advantage.
A fallen angel is a bond that is downgraded from investment grade (IG) to high yield (HY). The ratings move typically prompts forced selling from accounts unable to hold HY, resulting in price dislocations that widen the bond’s spread on downgrade to significantly higher levels than similarly rated peers. Generally speaking, fallen angels largely result from a single notch move from BBB- to BB+, and some 90% of the universe is rated BB.
The price dislocation upon downgrade opens strong return opportunities for investors: fallen angels tend to outperform not just IG, but also BB-rated bonds and the rest of HY, as shown in figure 1.
Figure 1. Fallen-angel performance vs rating-based indices
Source: Bloomberg and LOIM, as of Jan 2023. For illustrative purposes only. Past performance is not a guarantee of future returns.
What about the risk profile? Risk-adjusted statistics also display favourable characteristics, showing that since 2004 fallen angels have benefited from the highest Sharpe ratios relative to all ratings peers, including other BB-rated issuers.
Table 1. Performance statistics of fallen angels: total returns (EUR hedged) 2004-2022
Source: Bloomberg and LOIM, as of January 2023. For illustrative purposes only. Past performance is not a guarantee of future returns. Yields and ratings are subject to change and can vary over time.
As such, we see fallen angels representing a credit sweet spot for investors as they have tended to outperform all other ratings brackets.1 Yet investing in fallen angels also means avoiding falling knives, or bonds that continue to drop in credit quality and therefore price. Passive vehicles are ill-suited to avoid falling knives because they invest indiscriminately. An active approach, such as our Fallen Angels Recovery strategy, can be tailored to address heightened risks through systematic and fundamental credit research in order to optimise performance and steer clear of falling knives.
What drives the performance of fallen angels?
Both price recovery and carry drive fallen-angels performance, providing strong prospects for long-term investors holding the bonds to maturity because they benefit from the pull to par. In contrast, HY performance is driven only by carry, as shown in figure 2.
Figure 2. Performance attribution of fallen angels and HY bonds (USD hedged), 2004-2022
Source: Bloomberg Barclays Indices and LOIM, as of December 2022. Past performance is not a guarantee of future results. Mark-to-market includes unrealised losses from price declines (such as interest rate rises). For illustrative purposes only.
While a consistent exposure to fallen angels pays off, the timing is critical: investing at the point of downgrade maximises the price-recovery gains. After roughly two years, these gains tend to flatten out, as shown in figure 3. Overweighting new fallen angels is part of our strategy and is one of the key systematic tilts we use to exploit relative value.
Figure 3. Fallen angels: cumulative performance vs peer group, 1989-2022
Source: Bloomberg Barclays Indices and LOIM, as of December 2022. Downgrade in month 0. Past performance is not a guarantee of future results. Cumulative returns averaged across all fallen angels between 1989 and 2022. For illustrative purposes only.
The time is now
Following the re-pricing of fixed income in 2022, entry points for fallen angels currently look attractive, in our opinion. The outlook is advantageous, with fallen angels supply expected to rise from historical lows to long-term averages (figure 4). The historical supply of new fallen angels is highly correlated with economic cycles, as stressed economic and market environments lead to more downgrades by credit-rating agencies, potentially generating a wave of fallen angels. Companies on the cusp of downgrade may have limited access to capital markets, which could hit their cash buffers and lower financial metrics. At the same time, valuations are ticking higher, indicating potential credit stress and increased downgrade activity.
Figure 4. Expected net fallen-angels supply in the next 12 months
Source: Bloomberg, LOIM calculations. As of February 2023. Estimate using valuations and macro-variables. For illustrative purposes only.
Not only does greater supply expand the investment universe, it also drives performance and greater alpha potential. Generally speaking, the outlook for increased returns looking six-months forward is linked to greater supply in the previous six-months (figure 5). So, the more supply in the previous half year, the greater the performance potential in the subsequent half year.
Figure 5. Link between fallen-angel supply and performance
Source: Bloomberg, LOIM calculations. As of February 2023. Universe used inclusive of both IG and HY issuers. For illustrative purposes only. Yields and ratings are subject to change and can vary over time.
One investor concern regards the relatively shallow liquidity of the fallen-angels universe. Indeed, liquidity is lower than traditional HY but this can be mitigated by using an extended investment universe or investing outside the traditional fallen-angels universe in benign times. Only an active approach such as ours can do this, as passive vehicles invest exclusively in the narrowly defined universe.
The importance of being active
While fallen angels as a fixed-income segment represent attractive risk-adjusted return potential, we believe that an active approach stands to benefit investors most. We have designed our Fallen Angels Recovery strategy to deliver the best potential returns for investors through:
- Enhanced liquidity: we invest in liquid alternatives to historic fallen angels such as bonds from a fallen-angel issuer that were issued after the actual downgrade. This allows us to invest in newer and more liquid bonds and increases the capacity of the strategy
- Key systematic tilts: we replicate the fallen angels universe without systematic bias. Our team captures relative value in four key ways by preferring: shorter and newer fallen angels, those with the most pronounced price over-reaction at downgrade, and those in the BB rating bucket
- Fundamental (qualitative) research: to avoid falling knives we undertake rigorous credit analysis from the bottom up to ensure we invest only in those fallen angels that we expect to benefit from credit stabilisation and therefore price recovery. Fallen angels fall for a reason: it is critical to ensure that:
- the business profile is not compromised
- the company’s management has a suitable plan to stabilise and manage the business within the ‘BB’ range and there are sufficient resources to implement the plan within a reasonable time scale
Of course, we also consider sustainability in our fundamental credit process and are generally able to improve sustainability metrics relative to the high-yield index without compromising the key drivers of the fallen-angel strategy.
The case for a strategic allocationFrom higher Sharpe ratios to a favourable supply outlook, fallen angels are a sweet spot for corporate credit. Our strategy adds value through liquidity enhancement, systematic tilts and credit selection. In our view, fallen angels represent a superior HY allocation in fixed income, one that is not merely a tactical play but instead worthy of a dedicated, strategic allocation to lock in the strengths of this segment. Our next insight will consider how fallen angels can be used in a portfolio to add greater value. |
Sources
[1] Past performance is not a guarantee of future results.
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