Why are fallen angels the pick of high yield?

 

How could fallen angels offer a high-yield (HY) exposure of superior quality in a strategic allocation? We consider how investors can use these bonds to improve performance potential while mitigating relative ratings risk. In our previous insight of this three-part series, we made the case for a dedicated allocation to the segment due to the ability of price recovery to drive outperformance, and a compelling supply outlook.

 

 

Need to know   Fallen angels feature positive convexity characteristics and have historically outperformed high yield in most market environments Increasing the allocation to fallen angels in a high-yield strategy tends to improve risk-adjusted performance, with an increase in potential returns for a negligible change in risk We explore how fallen angels can be used to take advantage of their positive convexity qualities and to boost Sharpe ratios Active management is imperative to maximise the potential of fallen angels. Our Fallen Angels Recovery strategy is run by dedicated investment specialists aiming to exploit the best pockets of value

 

Across cycles, with better convexity

High-yield investors have a plethora of choice, so why should they opt for fallen angels? Fallen angels are bonds which have been downgraded from investment grade (IG) to HY, usually from BBB to BB. We see them as a persistent phenomenon through economic cycles, but with better convexity characteristics than peer HY credits.

Fallen angels tend to outperform other HY bonds in an economic recovery but fall less in a negative credit market. This net positive convexity stems from a reversal of the bond’s price overreaction at downgrade and from the segment’s higher exposure to recovering sectors. In addition, the strategy behaves like a high-quality BB-rated strategy in benign times as the fallen angels from the last crisis have recovered and consequently have a reduced beta.

Figure 1 shows how fallen angels outperform in most environments: since 2004 they have participated with 115% of the upside in positive credit markets but partook in 95% of the downside in negative credit markets.

 

Figure 1. Performance participation to high-yield market (beta), 2004-2022

Source: Bloomberg Barclays indices and LOIM calculations. As of December 2022. Past performance is not a guarantee of future results. For illustrative purposes only.

 

On a relative performance basis, the underperformance of fallen angels is generally low while the outperformance can be significant as credit markets recover, such as 2009 (figure 2). The recovery is especially strong for distressed sectors and issuers that are over-represented within the fallen-angels universe.

 

Figure 2. Performance statistics (annualised): fallen angels vs HY, 2005-2022

Source: Bloomberg and LOIM. As at December 2022. Past performance is not a guarantee of future results. Yields are subject to change and can vary over time. For illustrative purposes only.

 

Increasing exposure to fallen angels within HY

We believe that fallen angels warrant a higher weight within a strategic HY allocation than traditional weighting schemes would imply. Fallen angels have historically outperformed HY strategies, not to mention bonds rated BB, despite being higher rated than HY on average¹. This offers the potential for improving returns without moving lower down the credit spectrum. The higher credit quality can also be beneficial for large institutional investors, such as insurance companies, for whom capital charges are often linked to credit ratings.

Increasing the allocation of fallen angels within a HY strategy tends to improve overall risk-adjusted performance, with an increase in returns and negligible change in risk, as shown in the model in figure 3.

 

Figure 3. Fallen-angels allocation to a model HY portfolio, 2004-2023

Source: LOIM. For illustrative purposes only. Past performance is not indicative of future returns. Yields are subject to change and can vary over time. Covers December 2004-February 2023.

 

Recovering losses from forced selling

In an IG strategy, the cost of selling downgraded bonds is significant. This inefficiency is a natural outcome of the ‘buying high’ and ’selling low’ dynamic that is introduced by a selling rule based on credit ratings.  On average, bonds enter the IG universe at an issuance price of 100 while forced sales are at prices of 80. The losses from forced sales can be substantial and stand to significantly diminish gains from credit excess returns on an IG strategy.

To recover these losses, we recommend a strategic allocation to fallen angels. The size of the allocation required to recover these losses can be calculated as the ratio of the average loss from forced selling to the average outperformance of fallen angels. Our Alphorum fixed-income quarterly explores this aspect in more detail.

 

Flexible uses

Fallen angels can be used flexibly in a portfolio in a number of ways, each with potential benefits:

• Replacing or redefining a HY allocation with fallen angels for more convex exposure since fallen angels tend to outperform in a recovery while falling less in a selloff. Such convexity adds more asymmetry to the returns of a HY exposure regardless of the economic cycle. Fallen angels can also be paired with other HY areas to boost the convexity of a traditional HY allocation, or used as a standalone allocation
• Adding fallen angels to existing HY exposure can improve the overall investment rating of a portfolio without sacrificing prospective performance. For instance, including a portion of fallen angels could help outperform the HY benchmark: fallen angels are correlated with HY ratings but typically deliver better risk-adjusted returns
• Supplementing an IG portfolio with fallen angels (guidelines permitting) in order to prevent the forced selling of fallen angels when they are downgraded, which can cause significant losses or portfolio costs over time. We recommend a small strategic allocation to fallen angels to recover these losses. In addition, fallen angels can act as a yield enhancement to IG with attractive risk-adjusted returns and a relatively limited sacrifice of the average credit rating of a portfolio

 

Actively finding the best recovery potential

Active management is imperative to maximise the potential of fallen angels, including a specialist skillset adapted to the distinctive characteristics of this segment. Passive vehicles invest indiscriminately into fallen angels, including falling knives which negatively impact performance and risk profile. As such, exchange-traded funds focused on fallen angels fail to differentiate between the best bonds – those with the greatest recovery potential and expected stable ratings in the BB area – and the rest. Only an active approach can avoid falling knives.

Through managing Crossover portfolios rated BBB to BB since 2010, we have gained considerable expertise in this segment. In total, we manage CHF 28 billion in IG, Crossover and HY strategies². Our fallen angels team of five specialists is supported by strong research and risk capabilities, including 13 credit analysts, a sustainability team providing forward-looking analysis on aspects such as climate-risk, and three independent risk professionals. We believe our dedicated skillset is extremely relevant to adding alpha and could be used by multi-asset credit managers to improve their HY management.

Improving allocations Fallen angel bonds may have lost their investment grade rating, but the dynamics that play out beyond the downgrade provide a rich seam of investment opportunities. Our experience and analyses show that positioning a portfolio for greater strategic exposure to fallen angels in a HY allocation improves performance potential while mitigating relative ratings risk. In our next insight in this series, we show why active credit analysis across the ratings spectrum by sector is paramount to tapping the best opportunities, and present case studies from our experience of identifying fallen angels and falling knives.

 

For professional investors only
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