fixed income
4 ways to maximise fallen angels’ potential
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Need to know • Investing in fallen angel bonds1 could prove an attractive proposition for investors, but active management is crucial to addressing heightened risk and optimising return potential. • Given the significant differences between fallen angel bonds, how does our fallen angels recovery strategy ensure the leading outperformance prospects but also avoid the pitfalls of a fallen angel dipping deeper into high yield ratings, or becoming a falling knife? • In the systematic aspect of our strategy, we aim to capture relative value by preferring: shorter and newer fallen angels, those with the most pronounced price over-reaction at downgrade, and those in the BB rating bucket. |
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Please click on the tabs below to discover more about our active systematic tilts.
#1 New kid on the block
We tilt our strategy towards investing in the newest fallen angels. Our analysis spanning the past three decades finds that recently downgraded fallen angels tend to outperform those downgraded over 12 months ago (Figure 1). A large part of the price recovery in fallen angels occurs in the first year after the downgrade when the bonds tend to recover more strongly. After 12 months, this recovery loses steam.
Therefore, favouring the most recently downgraded bonds over older ones tends to capture the greatest outperformance potential, in our view.
Figure 1. Return statistics of fallen angels, sorted by months from downgrade
Source: LOIM calculations. Return figures are annualised. Sep 2004 - Jul 2021. Past performance is not a guarantee of future results.
#2 Shorter is better
Favouring relatively shorter maturity fallen angels is another way to improve performance prospects, in our opinion. By this we mean a maturity of less than 5 years when the bond is downgraded.
Over the longer term, fallen angels tend to be riskier than regular bonds. Therefore, bonds that have a longer maturity remain in the fallen angels index well after initial price pressure has dissipated. We find that excluding longer-dated fallen angels, particularly those downgraded more than 12 months ago, helps mitigate risk while maintaining returns.
Generally speaking, short-dated fallen angels outperform long-dated fallen angels from a risk-adjusted return perspective. From 2004-2021, excluding longer-dated fallen angels (except the newly downgraded ones) resulted in a 15% increase in Sharpe ratios, according to our calculations.
#3 Going to extremes
Locking in fallen angel return potential means choosing those bonds with the greatest credit spread reaction (or widening) after the downgrade relative to ratings peers. That’s because the bonds over-reacting most are also likely to provide the highest recovery potential too, as shown in figure 2.
Figure 2: US fallen angels performance over peers conditional on spread differential at downgrade: 1989-2021
Source: Bloomberg indices, LOIM calculations. Downgrade takes place in month 0. Past performance is not a guarantee of future results.
Furthermore, the spread overreaction of fallen angels vs peers is exacerbated in times of market stress, which is also likely to coincide with peak supply of new fallen angels. This tends to provide plentiful choice of relatively cheap fallen angels at opportune timing to participate in market recoveries (figure 3). As such, buying the most distressed fallen angels when supply is marked adds to performance drivers.
Figure 3. Fallen angels: supply dynamics vs market returns
Source: Bloomberg indices, LOIM calculations., as of end-July 2021.
#4 Only BBs need apply
The favourable risk-return characteristics of BB rated fallen angels lead us to overweight fallen angels in that ratings bucket. This is particularly relevant for recently downgraded fallen angels. We find that avoiding fallen angels that downgrade straight from investment grade to B+ or below is a useful systematic risk mitigation rule.
While the distress risk of fallen angels is comparable to high yield, this is disproportionately driven by those bonds that downgrade directly to B or below (Figure 4). Such bonds are therefore at greater risk of becoming falling knives and are avoided in our systematic approach.
Figure 4: Fallen angels final state (to maturity/exit): 1994-2021
Source: Bloomberg indices, LOIM calculations.
Conclusion
In addition, we also use active credit analysis to further avoid falling knives. This means applying rigorous bottom-up credit assessment to distinguish names that could suffer from further credit deterioration due to a poor outlook for their financial and business models.
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Tailored to maximise the opportunities in fallen angels, both our systematic tilts and credit research help capture the best prospects for investors. |
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To read the white paper on our fallen angels strategy, please click on the download button.
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