white papers
Fallen angels: spreading their wings
Corporate bond universes have been historically separated into investment-grade (IG) and high-yield (HY) credit ratings since the rise of the junk bond market during the high-yield boom of the 1980s. This boundary has resulted in persistent dislocations – exacerbated by passive investment based on these indices – including the performance of so-called fallen angels. They are companies which have recently been downgraded to high-yield status.
Our empirical study shows that fallen angels generate higher return and risk-adjusted performance1 than any other ratings-based credit segment and contribute heavily to the anomaly of BB instruments being the credit ‘sweet spot’. The impact of a ratings downgrade on a bond’s price is one cause, as such ‘price pressure’ is significant even for single-notch downgrades, such as from BBB- to BB+. Since more than 70% of fallen angels have been downgraded one step and over 90% remain BB-rated, we find that many are severely undervalued relative to rating-matched peers2.
Taking flight
This paper examines fallen angels from a range of perspectives, including credit fundamentals and valuations, performance characteristics and implementation techniques. In it, we undertake the following:
• Describe the size and supply dynamics of the market, and how it has developed over the last 20 years.
• Assess its risk/return profile and explain the key performance drivers compared with other credit segments.
• Consider how fallen angels can enhance portfolio performance during market recoveries – and explain how they can generate a convex exposure to the high-yield market.
• Compare fallen angels with the broader high-yield market to show how they are more heavily geared to market recoveries and less exposed to selloffs. This is because they are exposed to sectors and issuers that are recovering.
• Show that fallen angels have higher idiosyncratic risk with a greater probability of distress than rating-matched peers, meaning they require more monitoring than traditional BB-rated high-yield issuers.
• Make the case for fallen angels to be seen as an asset class: we address the key risks of implementing an exposure and the related portfolio-design considerations.
• Finally, we explore relative-value opportunities in the fallen angel market itself, emphasising the potential for adding value through an approach combining systematic rules and active management.
To read our white paper, ‘Fallen angels: spreading their wings’, please use the download button provided.
Sources
1 Past performance is not a guarantee of future results. Yields are subject to change and can vary over time.
2 For example, a fallen angel that is downgraded into the BB+ rating category is compared to the index of BB+ bonds for two years before and after the downgrade month.
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