Since we launched our Fallen Angels Recovery strategy in 2021, we have sought to capture the distinctive benefits of this segment in an active approach designed to address corporate ratings deterioration and take advantage of pricing dislocations. We look back on why careful credit selection is key to optimising potential in fallen angels and how dedicated research and analysis underpin our investment style.
The active advantage to harness strengths
Fallen-angel bonds1 offer many benefits for investors, yet this segment of corporate credit is also prone to idiosyncratic risks that could ultimately make issuers default. Our Fallen Angels Recovery strategy was designed to harness the inherent strengths of the segment while using active tools to limit downside, capture historical recovery patterns and expand the universe when supply is light.
The strategy’s launch in November 2021 took place when the global economy was recovering from the COVID-19 pandemic and corporations were preserving cash and repairing balance sheets. Widespread fiscal and monetary stimulus and ultra-low rates made fertile ground for a rapid improvement in corporate fundamentals. Consequently, companies started on a credit ratings upgrade wave since early 2022.
The oil shock from geopolitics and the Russia-Ukraine war threatened to set off another downgrade wave, largely centred on the eurozone. However, swift government support stopped this process in its tracks, allowing the fundamental improvement process to continue. The real-estate sector did provide some supply of new fallen angels that helped the strategy outperform. However, the volume was much smaller than the significant downgrades of energy and consumer companies in the past.
Fallen-angels supply did not witness a sustained uptick in 2023 and 2024 as the economy was buffeted by inflationary pressures but appeared poised for a soft landing that did not foster widespread rating cuts to high yield. Supply could easily change in the future, however, and we expect fallen angels to continue providing attractive entry points from forced selling in the years to come.
Read also: Fallen angels radar: a dynamic quarter for opportunities
A track record of enhancing potential
Our track record demonstrates that an active approach and bespoke strategy design are key to enhancing the potential of fallen angels while limiting potential losses for investors.
The past three years have been characterised by a general lack of supply of new fallen angels after the downgrade wave during 2020. In such a regime, our fallen-angels portfolio has behaved like a high-quality, high-yield portfolio. This bias has largely explained its performance patterns since inception.
The Fallen Angels Recovery strategy has employed fundamental bottom-up analysis and two decades of dedicated research to consistently beat the fallen-angels index since inception, regardless of supply fluctuations. For instance, when fallen-angels supply waned, the strategy employed active tilts to expand the universe and ensure deeper liquidity. The strategy has outperformed the high-yield benchmark when its quality bias was advantageous in 2022. When fallen-angels supply waned, the strategy employed active tilts to expand the universe. This meant it has reliably acted as a quality-bias portfolio that remained competitive with the returns of the high-yield index but with relatively lower drawdown.
Figure 1 shows 3-years of active management creating alpha: the Fallen Angels Recovery strategy has returned 7.6% since inception cumulatively, compared to 3.19% return for the fallen-angels index for an outperformance of 441 bps. The strategy also performed competitively against the high-yield benchmark, demonstrating its quality bias. We estimate that our active tilts translated into 45 bps worth of avoided underperformance annually compared to the high-yield benchmark in this period.
FIG. 1. Fallen Angels Recovery strategy gross composite2 performance vs strategy benchmark and fallen angels index3
FIG. 2. Summary risk indicator and synthetic risk and reward indicator4
Read also: Fallen angels: beyond the downgrade
Selecting the most investable fallen angels
Our active methodology has been instrumental to outperforming the index, which simply buys all fallen angels indiscriminately and exposes investors to further credit deterioration.
How does the Fallen Angels Recovery strategy use active management to address the drawbacks of a passive strategy? Watch our video.
To limit exposure to fallen angels that could default, we carefully analyse the business and financial profiles of individual companies. We also use precise timing and multiple systematic tilts, aiming to favour the most investable fallen angels. History shows that bond price dislocations are most marked just before or at the time of a bond’s downgrade from investment grade5. By systematically overweighting new fallen angels with the most extreme price reaction, we are able to tap into the maximum price dislocation. Lastly, to expand the universe beyond the index, we invest in other bonds issued by fallen angel issuers after they have been downgraded, provided they meet certain criteria.
Read also: Actively exploiting potential in fallen angels
Finding contrarian value in real estate
A contrarian approach is key to fallen angels as the strategy uncovers value by buying when the broader market sells. A key example was investing in the real estate sector when it was unloved.
The real estate sector – such as residential, commercial and retail landlords rather than developed buildings and builders – was the sector hardest hit by the rapid rise in interest rates from the beginning of 2022. Over the previous decade or so, many new real estate companies had issued debt in the unsecured bond markets to take advantage of very low interest rates at the time and the flexibility of borrowing on an unsecured basis.
Neither the companies, the agencies nor indeed investors had properly considered the impact of the rate cycle turning upwards. When rates rose, property valuations decreased, loan-to-value levels fell below the requirement for an investment-grade rating, downgrades followed, the cost of refinancing increased and investor demand fell.
Weathering a need to refinance
Real estate companies also had relatively short-term debt maturity profiles, which created the need to refinance a significant portion of their balance sheet every year. This led to liquidity concerns, doubts about the companies’ ability to refinance, rating downgrades and further erosion of investor confidence.
Thus, in 2022 and most of 2023, real estate company bonds were all very weak, with many trading at distressed levels and cash prices below 50 and even into the 30s. Yields were comfortably double digit and in a number of cases above 20% per annum6. Companies were unable to tap the primary market and there was little demand for existing paper in the secondary market.
We viewed this as an opportunity to invest because our research has shown that even in times of sector crisis most companies survive and most bonds recover and repay. We analysed the fundamentals of the players involved and found that they remained sound operationally: vacancies stayed low and rents were generally rising with inflation and being paid on time. We also found that the companies were working hard to refinance bonds maturing imminently and had a number of funding levers available, including accessing the secured bank loan market, raising equity and making disposals.
Selective investment in sufficiently liquid names
Our analysis focussed on a company’s liquidity position: how much cash (or equivalent) they held and how long it would last, assuming no access to the capital markets. At very low prices, we selectively added names that our analysis showed held sufficient liquidity to survive until interest rates retraced and investor sentiment improved.
The strategy has been materially overweight the sector for approximately two years7. Interest rates stabilised early in Q4 2023, investor sentiment has gradually improved, the unsecured market has re-opened, and the sector has rallied strongly over the last 18 months.
When crisis creates opportunity
After three years of success, we look forward to further downgrades creating more attractive entry points from price dislocations. One of the few certainties in investing is that there will always be another crisis in the future. In the meantime, we believe that remaining invested throughout downturns in an active approach remains the best way for investors to tap into long-term patterns that maximise potential.
