fixed income
Actively exploiting potential in fallen angels
Fallen angels fall for a reason; understanding the reason through an active approach helps avoid bonds that are likely to suffer from further downgrades and detract from performance. We delve into why credit analysis is key and illustrate our approach with two case studies.
Previous insights in this series explored the performance drivers of fallen angels and the favourable supply outlook; and how adding fallen angels to an allocation could improve overall risk-adjusted returns.
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Navigating distress rates
Long-term risk can be higher in fallen angels, even if investors are compensated by significantly cheaper valuations. The distress probabilities of fallen angels (figure 1) are comparable to the entirety of high yield despite being better rated. This reflects the fact that credit ratings have momentum and, therefore, a downgraded bond can be more likely to suffer from further rating cuts. In other words, fallen angels are downgraded for a reason and investors need to be comfortable that a company can address any issues to prevent further rating declines.
Within the segment, it is crucial to distinguish between fallen angels with a stable credit quality around BB, and falling knives, which risk further deterioration in their credit ratings and possible default. Different bonds are downgraded for different reasons and idiosyncratic risks remain high in the fallen-angels universe. Such risks underscore the importance of rigorous bottom-up credit research.
Figure 1. Fallen-angel distress rates in US corporate bonds: 1994-2022
Source: Bloomberg indices, LOIM calculations. As of March 2023. Distress is defined as a bond’s exit price from the universe of 50 or below. For illustrative purposes only. Past performance is not a guarantee of future returns.
Harvesting overreaction premia
Exposure to distressed sectors is often an important source of harvesting the overreaction premia in fallen angels. Sectors that come under the greatest ratings pressure tend to overreact, with an even greater overreaction from the fallen angels within that sector.
As shown in figure 2, there was a large rise in fallen angels in the technology and telecoms sector in 2002, for instance. By the middle of the decade, downgrades in the automotive sector dominated. Concentration to the banking sector increased after the financial crisis in 2008 and peaked following the eurozone sovereign-debt crisis in 2011. Energy downgrades multiplied in 2016 as a result of the commodities crash and again in 2020 due to low prices in the aftermath of the COVID-19 crisis.
Figure 2. Sector weights in the fallen-angels universe, 2001-2022
Source: Bloomberg indices, LOIM calculations. As of March 2023. For illustrative purposes only.
In fact, the sector bias of fallen-angels performance is critical and accounts for almost half of the segment’s total outperformance compared to high yield as a whole (figure 3), at over 1% per annum or more than 20% cumulatively over 20 years.
Figure 3. Fallen-angels sector outperformance over high yield: cumulative, 2004-2022
Source: Bloomberg indices, LOIM calculations. For illustrative purposes only. As of March 2023. Past performance is not indicative of future returns.
The importance of sectors to fallen-angels performance elevates the need for sector specialists able to span the rating spectrum to identify opportunities and mitigate risk. Our decade of experience in Crossover credit rated BBB to BB gives us a unique perspective across rating categories, especially at the key threshold between IG and HY.
We are deeply familiar with how forced selling impacts fallen angels and have dedicated teams to best capture the valuation dislocations and price recovery. We know how the market overreacts and how to tap into the opportunities that arise as a result. Our credit specialists are organised by sector across the gamut of ratings and have years of experience investing in a multitude of fallen angels while steering clear of falling knives.
Active tilts: systematic filters and credit analysis
How is our approach to fallen angels different? Focusing on both beta and alpha, our strategy is designed to exploit relative value from a systematic perspective as well as identify falling knives through dedicated credit research.
From a systematic perspective, our filters include favouring new fallen angels whose prices have overreacted negatively relative to peers. Consequently, we are underweight older fallen angels. We also tilt towards fallen angels that are rated BB, exhibit shorter duration and show the greatest credit spread reaction after the downgrade.
Our fundamental credit analysts are sector specialists engaged in dedicated bottom-up analysis to filter out bonds that risk further credit deterioration. As such, we differentiate between downgrades based on a temporary change in a company’s financial profile versus downgrades that reflect a longer-term negative assessment of the company’s business profile. Here, the ‘why’ of a downgrade is important because it dictates future potential and risks. Such analysis enables us to invest only in those fallen angels that we expect to benefit from credit stabilisation and price recovery.
Please click on the tabs below to see our credit analysis in action. The case study of Ford1 illustrates a well-suited fallen angel while Adler1 demonstrates a falling knife.
Ford, a fallen angel
Ford2 Motor’s 3.664% bond due 08/09/24 was downgraded to high yield in the throes of the pandemic in March 2020. The downgrade reflected the operating and market challenges facing the well-known automotive company when it was undertaking an extensive restructuring plan, and cash flow and profitability were weak.
Despite this deterioration in the company’s financial metrics, its business profile showed positive signs. It had a strong position in the profitable truck segment where it was a large-scale manufacturer. As the company executed its margin recovery plan and drivetrain shifts, it also invested in developing electric vehicles where its models benefitted from positive acceptance.
Our analysis found a strong credit performance, prudent risk management and a large capital structure of its captive finance business. We found no signs of the business or industry being in structural decline and determined it could withstand pandemic-driven challenges. We concluded that the bond was less likely to suffer further sharp price falls, though its return to an investment-grade rating will require Ford to deliver on its 2023 8% adjusted EBIT margin target on a sustainable basis.
As such, we deemed it a well-suited fallen angel.
Ford: a decade of ups, downs and pulling to par
Explore the interactive graphic below tracking the evolution of Ford’s creditworthiness over the past decade.
Source: LOIM. For illustrative purposes only. Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document. Past performance is not indicative of future results. Ratings subject to change
Adler, a falling knife
ADO properties3 was downgraded from investment grade in 2020 following its acquisition of Adler Real Estate. The ratings cut reflected a combination of lower quality assets, weakened financial metrics and unclear management and governance.
In September 2021, questions were raised in the German parliament about the three-way merger that created Adler Group, whether the German regulator BaFin had reviewed the transaction appropriately and if (or how) Austrian entrepreneur Cevdet Caner was involved. A report from a short-seller, Viceroy Research, made additional allegations about governance, valuations and property transactions.
Adler announced a material disposal strategy in October 2021 that aimed to reduce debt by selling its more attractive investment properties and thereby increase its exposure to riskier development projects, weakening its business profile and credit quality. The strategy for the remaining business was vague, governance issues had not been addressed and it was not clear to us that the new business would have access to the unsecured bond market – all of which led us to conclude that Adler did not have a viable long-term business and was to be treated as a falling knife.
Therefore, when the Fallen Angels Recovery strategy launched in November 2021, we chose not to buy the borrower’s 1.5% bond due 07/26/2024 priced at 91.25.
Adler Group was downgraded to CCC, with negative outlook (NO) in May 2022 and would have left the index at a price of about 60. It later fell towards a price of 40 when it was cut to CC NO in December 2022. Although it has recovered somewhat since, many of its issues remain unresolved: the company has struggled to find an auditor and is currently going through a restructuring exercise, which is being challenged in the courts.
Figure 4 illustrates how quickly a bond price can fall when faced with such challenges, and how important careful bottom-up analysis is to prevent exposure.
Figure 4. Cut down: price declines of the Adler 1.5% bond due 07/26/2024
Source: Bloomberg. For illustrative purposes. As of April 2023. Past performance is not a guarantee of future results.
Optimising return potentialFallen angels represent attractive prospects for fixed-income investors, but the segment is by no means uniform. Excluding falling knives requires an active approach to select only the best names and mitigate risk from those in danger of further downgrades or default. Our approach couples dedicated systematic and credit research teams to filter the universe and optimise return potential. |
Sources
[1] Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.
[2] The case studies provided in this document are for illustrative purposes only and do not purport to be recommendation of an investment in, or a comprehensive statement of all of the factors or considerations which may be relevant to an investment in, the referenced securities. The case studies have been selected to illustrate the investment process undertaken by the Manager in respect of a certain type of investment, but may not be representative of the Fund's past or future portfolio of investments as a whole and it should be understood that the case studies of themselves will not be sufficient to give a clear and balanced view of the investment process undertaken by the Manager or of the composition of the investment portfolio of the Fund now or in the future.
[3] The case studies provided in this document are for illustrative purposes only and do not purport to be recommendation of an investment in, or a comprehensive statement of all of the factors or considerations which may be relevant to an investment in, the referenced securities. The case studies have been selected to illustrate the investment process undertaken by the Manager in respect of a certain type of investment, but may not be representative of the Fund's past or future portfolio of investments as a whole and it should be understood that the case studies of themselves will not be sufficient to give a clear and balanced view of the investment process undertaken by the Manager or of the composition of the investment portfolio of the Fund now or in the future.
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