investment viewpoints

Fallen angels: beyond the downgrade

Fallen angels: beyond the downgrade
Anando Maitra, PhD, CFA - Head of Systematic Research and Portfolio Manager

Anando Maitra, PhD, CFA

Head of Systematic Research and Portfolio Manager
Ashton Parker - Head of Credit Research

Ashton Parker

Head of Credit Research

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.



Need to know

  • A bond’s downgrade to high yield causes price dislocations from forced selling that open strong risk-adjusted return opportunities for investors; the price recovery from such dislocations drives outperformance. Our research suggests that a fallen-angel strategy generally outperforms high yield over time
  • Entry points for fallen angels look attractive and we expect an uptick in supply given the economic backdrop. Generally, greater past supply has been linked to better future performance
  • Our Fallen Angels Recovery strategy is designed to optimise potential returns for investors through enhanced liquidity, systematic tilts and fundamental research
  • We believe investors should consider a dedicated and strategic allocation to the segment as an alternative to traditional high yield



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

FA Insights 1 - Fig 1 - perf vs rating-01.svg

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  

FA Insights 1 - Table 1 - Perf stats-01.svgSource: 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

FA Insights 1 - Fig 2 - Perf attribution-01.svg

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

FA Insights 1 - Fig 3 - Cum perf-01.svg

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

FA Insights 1 - Fig 4 - Net supply-01.svg

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

FA Insights 1 - Fig 5 - Supply and perf-01.svg

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 allocation

From 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.



[1] Past performance is not a guarantee of future results.

How do we capture inefficiencies in high yield to improve performance? Learn more about our Fallen Angels Recovery strategy by clicking here.

important information.

For professional investors only
This document is issued by Lombard Odier Asset Management (Europe) Limited, authorised and regulated by the Financial Conduct Authority (the “FCA”), and entered on the FCA register with registration number 515393.
Lombard Odier Investment Managers (“LOIM”) is a trade name.
This document is provided for information purposes only and does not constitute an offer or a recommendation to purchase or sell any security or service. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful. This material does not contain personalized recommendations or advice and is not intended to substitute any professional advice on investment in financial products. Before entering into any transaction, an investor should consider carefully the suitability of a transaction to his/her particular circumstances and, where necessary, obtain independent professional advice in respect of risks, as well as any legal, regulatory, credit, tax, and accounting consequences. This document is the property of LOIM and is addressed to its recipient exclusively for their personal use. It may not be reproduced (in whole or in part), transmitted, modified, or used for any other purpose without the prior written permission of LOIM. This material contains the opinions of LOIM, as at the date of issue.
Neither this document nor any copy thereof may be sent, taken into, or distributed in the United States of America, any of its territories or possessions or areas subject to its jurisdiction, or to or for the benefit of a United States Person. For this purpose, the term "United States Person" shall mean any citizen, national or resident of the United States of America, partnership organized or existing in any state, territory or possession of the United States of America, a corporation organized under the laws of the United States or of any state, territory or possession thereof, or any estate or trust that is subject to United States Federal income tax regardless of the source of its income.
Source of the figures: Unless otherwise stated, figures are prepared by LOIM.
Models may be misspecified, badly implemented or may become inoperative when significant changes take place in the financial markets or in the organization. Such a model could unduly influence portfolio management and expose to losses.
Although certain information has been obtained from public sources believed to be reliable, without independent verification, we cannot guarantee its accuracy or the completeness of all information available from public sources.
Views and opinions expressed are for informational purposes only and do not constitute a recommendation by LOIM to buy, sell or hold any security. Views and opinions are current as of the date of this presentation and may be subject to change. They should not be construed as investment advice.
No part of this material may be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorised agent of the recipient, without Lombard Odier Asset Management (Europe) Limited prior consent. In the United Kingdom, this material is a marketing material and has been approved by Lombard Odier Asset Management (Europe) Limited  which is authorized and regulated by the FCA. ©2023 Lombard Odier IM. All rights reserved.