What Can Drive Fallen Angel Performance From Here?

Fallen angels (as represented by the ICE US Fallen Angel High Yield 10% Constrained Index, “H0CF”) underperformed the broader high yield market (as represented by the ICE BofA US High Yield Index, “H0A0”) by 0.25% in August (0.04% vs 0.29%). Year-to-date, fallen angels are lagging by 0.99% (6.23% vs 7.22%). Lower credit quality issuers continue to outperform due to robust U.S. growth data and better-than-expected earnings with the CCC & Lower US HY Index returning 13.62% YTD. Goldman Sachs has reduced its 12-month U.S. recession probability to 15%, crediting the positive inflation news and labor market data. As a higher quality strategy with a significantly greater tilt to BB rated bonds versus the broad market, fallen angels have not participated in the recent rally to the same extent as the lower quality broad high yield market.

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Looking Ahead to Potential Fallen Angel Drivers

High Yield YTD Total Return

Source: ICE Data Services, VanEck. ICE BofA BB US High Yield Index, ICE BofA Single-B US High Yield Index and ICE BofA CCC & Lower US High Yield Index. Please see definition for these and other terms referenced herein in the disclosures and definitions portion of this blog. Past performance is no guarantee of future results. Index performance is not representative of fund performance. It is not possible to invest in an index.

In terms of fund flows, high yield corporates have experienced approximately $1bn in outflows while Treasury products added approximately $9bn just in August. Short duration saw outflows, but the other categories (Floating, Ultra Short, Intermediate and Long) registered inflows.

Can price returns drive outperformance going forward?

The price return of fallen angels has been a key differentiator versus broad HY from a total return perspective, driven by the systematic purchases of oversold/undervalued bonds that have been downgraded to high yield and have tended to recover in the months after being downgraded.

Price return this year, however, has been a detractor. Two primary factors contributing to this decline are the scarcity of fallen angels and their longer duration. For instance, even though rising stars have historically boosted performance during periods of low downgrade volumes, the extended duration of rising stars in 2023 (accounting for 35% of the year's starting index value) has meant that they have not been additive to performance this year. With an average price of $88.75, fallen angels now have a lower average price compared to the broader high-yield market.

We believe there are several potential related scenarios that could reignite price performance as a driver of outperformance, as seen historically. First, corporate profits and financial positions might weaken due to rising debt costs and the possibility of an economic slowdown, leading to wider credit spreads. Lower-quality issuers, with limited capacity to refinance and sustain higher interest costs, may be particularly vulnerable. Given that credit spreads are currently near their tightest levels of the year, there's room for significant widening if a less favorable economic environment materializes. In a scenario where credit quality deteriorates and spreads widen, higher-quality bonds may outperform, potentially favoring fallen angels on a relative basis.

Similarly, in a more risk-averse environment, bond yields are likely to decrease from their current elevated levels, which could benefit longer-duration fallen angels compared to the broader high-yield market, all else equal. More importantly, a scenario of credit weakness could lead to a higher volume of new fallen angels. While we haven't witnessed a significant wave of downgrades since 2020, credit rating downgrades tend to lag behind changes in fundamentals. Although the overall credit market remains relatively robust, it's worth noting that credit metrics are beginning to reflect lower profits and increased funding costs, and defaults among highly leveraged borrowers are on the rise. According to J.P. Morgan, the value of defaults and distressed exchanges year-to-date is already approaching the eighth highest annual amount on record, with the potential to become the third-largest annual total by year-end. While it's impossible to predict the exact timing, given these broader dynamics, it's difficult to envision a scenario where downgrades do not increase. Historically, fallen angel price returns have been at their strongest, and their outperformance against the broader high-yield market has been most pronounced when a significant number of downgraded bonds, typically deeply discounted, enter the market.

Fallen Angels Overall Statistics: Fallen angels yields increased by 20bps to 7.45 and broad HY yields by 12bps to 8.48 in August. The 10Y yield increased by 12bps to 4.09 but it saw a dip at the end of the month from 4.34. Spreads saw some widening while duration was almost unchanged. The fallen angel market value has declined with almost 3 times more rising stars than fallen angels so far this year. Defaults in the high yield market have begun to pick up and fallen angels have seen 0.50% default par (approx. $628m in par amount for just one issuer) vs 0.97% default par (approx. $13,368m in par amount for 11 issuers) in broad HY.

Source: ICE Data Services, VanEck. Fallen Angels: ICE US Fallen Angel High Yield 10% Constrained Index. Broad HY: ICE BofA US High Yield Index. OAS refers to “option-adjusted spread.” Please see definition for this and other terms referenced herein in the disclosures and definitions portion of this blog. Past performance is no guarantee of future results. Index performance is not representative of fund performance. It is not possible to invest in an index.

New Fallen Angels: Two fallen angels were added in August, both in the banking sector: Associated Banc-Corp and Valley National Bancorp Tier 2 notes. These two were part of the broader banking sector downgrade by the rating agencies warning that funding risks and commercial real estate exposure may bring weaker profitability amid higher for longer interest rates. Over the last 12 and six months, Associated Banc-Corp posted price returns of -1.34% and -3.25%, respectively, while Valley National Bancorp posted -9.76% and -11.87%, respectively. With these latest additions, fallen angels account for 11.84% of index weight YTD.

Source: ICE Data Services, VanEck. Fallen Angels: ICE US Fallen Angel High Yield 10% Constrained Index. Past performance is no guarantee of future results. Not a recommendation to buy or sell any of the names/securities mentioned herein. Index performance is not representative of fund performance. It is not possible to invest in an index.

Rising Stars: One issuer exited the index in August, Howmet Aerospace (Howmet), as Fitch upgraded it to ‘BBB’. Howmet has been steadily improving its profitability, which is supported by the company's leading and defensible market position and differentiated technology portfolio. Howmet Aerospace was part of the Covid wave of downgrades in April 2020, entering the index at $97.24 with a 1.30% exposure; it now exits at $99.55 and 2.04%. Over the last 12 months, Howmet Aerospace posted a price return -0.02% vs 1.82% for the broad high yield market, however, during its time in the fallen angel index, it posted price return of 2.38% vs 0.30% for broad high yield. Rising stars continue to be one of the main topics this year, even as their outperformance over broad HY before exiting the fallen angel index has been lower than the historical average as mentioned above.

Source: ICE Data Services, VanEck. Fallen Angels: ICE US Fallen Angel High Yield 10% Constrained Index. Past performance is no guarantee of future results. Not a recommendation to buy or sell any of the names/securities mentioned herein. Index performance is not representative of fund performance. It is not possible to invest in an index.

Fallen Angels Performance by Sector: There were no significant sector composition changes in August. The top three performers were Telecom (+2.83%), Consumer Goods (+1.39%) and Real Estate (1.33%) which were also the only sectors to see price increases in August, while the worst performers were Retail (-1.52%), Capital Goods (-1.22%) and Insurance (-1.15%). Leisure saw its exposure decreased as a large Las Vegas Sand issue was removed due to its maturity being shorter than 12 months away. Spreads widened in most sectors and prices decreased in all but three sectors, which were the same as the top three performers mentioned above. As of month-end, 63% of fallen angels are now trading in the $80s, 37% in the $90s and no sector is above par.

Source: ICE Data Services, VanEck. Fallen Angels: ICE US Fallen Angel High Yield 10% Constrained Index. Not intended as a recommendation to invest or divest in any of the sectors mentioned herein. Index performance is not representative of fund performance. It is not possible to invest in an index.

Fallen Angels Performance by Rating: The BB-rated bucket was the only ratings category that saw spreads widen and price fall, thus the negative return.

Source: ICE Data Services, VanEck. Does not have securities for all months of selected period. Returns are based on partial period data. Fallen Angels: ICE US Fallen Angel High Yield 10% Constrained Index. Past performance is no guarantee of future results. Index performance is not representative of fund performance. It is not possible to invest in an index.