Angel delight: investing in 'fallen angel' bonds
It’s raining bonds, investment-grade bonds. We are seeing an increasing number of bonds falling out of the investment-grade heavens and being ‘junked’ due to the bleak economic fallout from COVID-19.
Generally speaking, a ‘fallen angel’ is a bond that has been downgraded to BB+ or below by two or more of the major rating agencies, thereby losing its investment grade (IG) status and moving into the high yield or ‘junk’ category.
As the name suggests, this isn’t good news for the corporate bond issuer. It can be a costly event due to higher refinancing costs, and possibly lead to a higher chance of default, which in turn could have a negative effect on the bond investors as well.
But for some investors, we believe fallen angels may present opportunities – a bit like that packet of Angel Delight in the back of your cupboard at the moment when quarantine stockpiling has left the supermarket shelves bare!
In March we saw the fastest two-week pace of downgrades on records going back to at least 2002. This has amounted to $127 billion of new fallen angel bonds in the year to date, including household names like Ford and Marks & Spencer. Many more are expected, which can be seen in current market pricing as a substantial number of BBB-rated developed-market IG bonds trade at or above BB-rated index spreads.
However, this isn’t a new phenomenon; as Madeleine pointed out last year, even before the recent market meltdown we were anxious about the proportion of the bond market that was vulnerable to falling into this category, having predicted $100 billion of downgrades regardless of economic conditions. We now expect an additional circa $470 billion of fallen angels to materialise, under an economic backdrop broadly equivalent to the Scenario 1 outlined by Tim here, and assuming the oil price stays roughly where it is. The sharp fall in the oil price has been the main driver of that increase from Madeleine’s predictions last year.
Fallen angels can pose a significant risk to IG credit managers as the bonds fall out of their benchmarks, obliging many managers – from IG index funds to insurance companies that are subject to capital requirements under Solvency II requirements – to become forced sellers. Often this is the worst time to sell, as fallen angel bond prices can initially overshoot the intrinsic value due to the anticipation of a downgrade and technical pressure from mass selling.
At the bottom of patience, one finds heaven
As pointed out in an earlier article from our colleagues in the Index team, over the medium to long term, fallen angel issuers have the opportunity to recover from their downgrade. These issuers have a high incentive to regain their IG status in order to maintain a low financing cost over the longer term. They are often of a higher quality than the average bond in the high-yield universe, as they will usually have been issued by more established companies than originally issued high-yield credit.
As a result, if a credit portfolio has the flexibility to hold onto these bonds and avoid selling with the crowd, they could benefit from a potential recovery. This comes not least from price normalisation, as research shows these fallen angels often enter the index 1.5% cheaper than their new high-yield peers, but also from their often higher quality and potential to regain IG status.
A more recent consideration is that, on Thursday last week, the US Federal Reserve (‘Fed’) announced some changes to its Secondary Market Corporate Credit Facility that appear to be supportive for these bonds.
This comes both through the Fed’s inclusion in its purchases of individual corporate bonds that have been downgraded to a BB rating from 22 March onwards (as long as they are rated at least BB- by two or more major rating agencies at time of purchase) and through the Fed’s inclusion of high-yield ETFs in the programme.
Yet the Fed stepping in may nonetheless be a bit of a double-edged sword for fallen angel investors, as it is likely to disrupt the historical dynamic explained above. The increased demand should be supportive for the bond prices and make holding onto fallen angels less risky, but also potentially erodes some of the premium for the high-yield buyers.
Looking back at its performance since 2006, the Bloomberg Barclays US High Yield Fallen Angels Index has outperformed the broader US High Yield Index in most years, as you can see below. The Fallen Angels index typically has a longer duration, however; even in years when interest rates increased, it still outperformed the broader market – such as in 2009, 2013, 2015 and 2016.
Therefore, we believe this segment of the market can potentially offer a relatively ‘sweet’ investment for a long-term investor who has the flexibility and ‘stomach’ to hold onto the bonds after a downgrade event. We currently have a strategic allocation to fallen angels within some of our multi-asset funds.
Of course, this kind of investment doesn’t come without risk; there is usually always a good reason why a bond is downgraded and there is certainly no guarantee such bonds will always recover. For example, as I alluded to earlier, the energy sector is particularly vulnerable this time around, given the drop in oil prices and that the near-term economic outlook is hugely uncertain.
As always, the investment risk needs be considered in the context of the wider portfolio and your client’s investment objectives and time horizon.