Understanding fallen angel bonds – a persistent opportunity in high yield

Many investors assume that a bond downgraded from investment grade (IG) to high yield (HY) is simply bad news. Not always.

In reality, these ‘fallen angels’ are often downgraded despite their credit fundamentals remaining intact. Therefore, at the point of downgrade they become attractively priced – creating a time-tested opportunity that has historically rewarded patient investors.

In this article, we explain what fallen angels are, why they tend to deliver stronger long‑term results than traditional HY bonds, and how an active approach to this credit segment can help investors capture their benefits more fully.

Read also: 3 years of catching fallen angels

Explaining fallen angels

A fallen angel is a corporate bond that has descended from IG status into HY. This typically happens when a company faces short-term challenges, or economic or market conditions deteriorate and credit-rating agencies become more bearish.

Crucially, downgrades often prompt forced selling by investors, such as pensions and insurance funds, which are only allowed to hold IG bonds. This technical pressure can cause spreads to widen sharply, pushing prices to levels that misrepresent the issuer’s true creditworthiness.

Most fallen angels experience only a modest ratings decline – often from BBB‑ to BB+, meaning:

• About 90% of the fallen‑angel universe is rated BB¹, the highest tier of HY
• These bonds typically retain stronger fundamentals than the broader HY market.

Because of this initial mispricing relative to credit fundamentals, fallen angels have historically outperformed not only IG bonds but also other BB‑rated and HY peers.

FIG 1. Fallen angels: upper quality high-yield bonds with attractive spreads²

The drivers of fallen angels performance

Fallen angels sit in a credit ‘sweet spot’, in our view, thanks to two key return drivers:

• Price recovery. Once forced selling eases, prices often rebound as the market reassesses the issuer’s underlying strength
• Carry. Investors accrue the additional yield that compensates for HY risk.

Together, these drivers create a sustained pull‑to‑par effect that is best captured by holding these bonds over time.

FIG 2. Price recovery and carry drive fallen angels returns³

How can fallen angels improve a high yield portfolio?

Because of the performance and quality characteristics of fallen angels, increasing their weight within a HY allocation can meaningfully enhance portfolio robustness.

Two practical portfolio use cases include:

1. Part of a HY exposure
   Fallen angels move in line with HY markets but have historically delivered superior performance. Adding them to an existing HY allocation can upgrade overall portfolio quality and improve return potential
2. Within IG portfolios
   Including fallen angels can offset the impact of forced selling that occurs when a bond falls out of IG indices. It also enhances portfolio yield with minimal effect on the overall average credit rating.

Active or passive?

Not all fallen angels recover. Some actually do show credit deterioration and continue to descend the ratings scale. These are so‑called falling knives.

Passive strategies, which replicate an index mechanically, must by definition hold every newly downgraded bond, including those whose fundamentals are weakening.

An active approach can avoid these pitfalls by:

• Selecting fallen angels with strong recovery prospects – knowing the fundamentals of the issuer before the downgrade helps
• Analysing company fundamentals in real time and excluding issuers whose credit quality is deteriorating.

This is the foundation of strategies such as LOIM Fallen Angels Recovery, which combines systematic screening, fundamental research and a specialised team dedicated to crossover and fallen‑angel credit.

FIG 3. Fallen angel ETFs lag high yield and investment grade passive vehicles⁴

Read also: 4 passive pitfalls: why fallen-angel bonds need active management

The bottom line

Fallen angels are not distressed bonds. In contrast, they are mispriced opportunities mainly created by technical rules and volatility. For credit investors seeking enhanced returns, better quality and a compelling addition to HY or IG allocations, fallen angels can play a powerful role.

That said, an active approach remains essential to avoiding falling knives and unlocking the full potential of this attractive credit segment, in our view.