Fixed Income
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
|
---|
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 allocationsFallen 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. |
Sources
[1] Source: Bloomberg and LOIM. Past performance is not a guarantee of future results. Refers to fallen-angels performance vs ratings-based indices from 2004-2022.
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.
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.