By Syed Zamil, Insight Investment
Fallen angels, investment grade bonds that have been downgraded to sub investment grade or high yield bonds, are often overlooked, but offer potentially rewarding credit opportunities.
- Fallen angels have delivered equity-like returns at bond-like risk. Over the past 20 years, total returns in this asset class have rivalled stocks. Fallen angels primarily comprise of the highest quality high yield bonds and yet, it has outpaced the broad high yield asset class by 2% per year, over this period. Further, with a yield of approximately 7%, fallen angels also offer an attractive income to investors. Being a publicly traded asset, fallen angels also offer a more liquid compliment than private investments.
- Fallen angels are misunderstood and sometimes overlooked. Fallen angels, bonds downgraded from investment grade to high yield, suffer from a technical dislocation or, more bluntly, a technical sell-off, at the time of downgrade and thus offers investors an opportunity to capture the mispricing.
- Fallen angels perform well in periods following elevated downgrades. When downgrades are elevated, the opportunity increases. More bonds get downgraded, which leads to more mispriced bonds, which leads to greater opportunities, generally.
After several years of muted downgrades, we believe more downgrades are coming, which should be a tailwind for fallen angels. Quantitative easing is over, and rates have normalised…which has resulted in higher refinancing costs.
BBB-bonds (lowest category of investment grade) are facing higher costs in servicing their debt (as measured by leverage, interest coverage ratio, etc.), which may lead to heightened downgrade activity.
Also read: Selective Strength in a Policy-Driven Market
What are the Implications for Institutional Investors?
Fallen angels offer investors access to higher quality high yield bonds that offer low defaults, attractive total return and yield potential. Against a backdrop of “tariff tantrum”, and a slowing economic backdrop, fallen angels offer diversification benefits to stocks, which can experience bouts of heightened volatility and extended periods of drawdowns.
From a risk perspective, fallen angels sit almost exactly in the middle of the efficient frontier between riskier assets like stocks and privates, and low risk assets like treasuries, and global aggregate bonds. As such we would submit that fallen angels can be a strategic holding in a diversified asset allocation framework.
