Rating Migrations Shake Up Sector Exposure

Fallen angels (as represented by the ICE US Fallen Angel High Yield 10% Constrained Index, “H0CF”) outperformed broad HY (as represented by the ICE BofA US High Yield Index, “H0A0”) by 0.30% (1.43% vs 1.13%) in March, bringing returns in line year to date (3.70% vs 3.72%). Fallen angel’s longer duration vs broad HY was a tailwind in March as it contributed to more than 100% of the outperformance, with rates continuing to be very volatile. The bond market was whipsawed by swings in the U.S. Federal Reserve’s (Fed’s) expectations over the quarter as growth and inflation expectations continued to adjust, while the chaos created by Silicon Valley Bank (SVB) created a banking mini-crisis in March. Short end rates increased, as the Fed maintained its stand and cumulatively raised rates by 0.50% (+0.25% in both meetings) in Q1. During the quarter, the 2s10s yield curve hit its most inverted level in approximately four decades, before sharply steepening as stress in the banking sector intensified (but remained inverted). Volatility was evident in credit spreads as well. Although the first two months of the year saw gradually tightening spreads, the quarter ended with a significant widening as banking sector concerns emerged and the narrative shifted through the quarter from soft landing to no-landing, and back again to some type of bumpier landing.

U.S. Treasury Curve

Source: US Treasury. 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 addition to widening credit spreads, the other narrative that may be unfolding revolves around a major shift in the sector allocation of fallen angels. Since index inception in December 2003, fallen angels have been represented in various sectors, and usually, such allocations came with a contrarian view, meaning that investors may have been hesitant to allocate as these were usually under some sort of distress. As a result, significant price adjustments occurred, and issuers who entered the fallen angel index experienced a remarkable recovery, offering considerable upside. During Q1, we saw the biggest allocation change since the wave of downgrades in April, 2020.

• Energy: fallen angels’ highest sector weight dropped to 22% after being as high as 30% in April 2020, as Western Midstream was upgraded. Western Midstream entered the fallen angel index at a par weighted price of $85.54 and exited at $90.44.
• Autos: exposure increased to 18%, as Nissan was downgraded in early March, joining Ford, which has been in the index with a 10% weight, since April 2020. The last time the fallen angel index had auto exposure of 18% or more was in 2005, when GM and Ford were downgraded.
• Banking: so far, the mini-crisis in banking has resulted in only one fallen angel: First Republic, which entered the index with a small weight. The pipeline of more banking downgrades is currently limited, despite rating agencies expecting more pressure on the sector as the Fed continues to fight inflation.

Over time, sector themes within fallen angels have driven differentiated returns and our expectation is that, with additional systematic or idiosyncratic downgrades, this dynamic will continue.

Fallen Angel Historical Sector Allocation

Source: ICE Data Services, VanEck. 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.

Fallen Angels Overall Stats: Fallen angels bond spreads widened by 30bps in March vs 38bps for broad high yield, but ended the quarter modestly tighter. During the quarter, fallen angel spreads tightened from their year-end levels and hit their lowest level since mid-2022 on March 6, but banking sector stress drove a surge in rate volatility that took spreads from 273 to 375, before tightening back down to 325 as the Fed intervened and alleviated fears of a much wider contagion from the banking sector chaos. Although spreads widened in March, they are still not at recessionary levels. However, absolute yield levels can provide a return cushion if spreads continue to widen.

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: The first quarter brought four fallen angels into the index in total, adding 9.85%. As mentioned last month, Nissan was downgraded by S&P on March 7, as S&P sees the automotive industry having a tough time over the coming years due to prolonged supply chain disruptions, high costs, a global economic slowdown and rising interest rates, and thus expects Nissan earnings to be weaker than were previously assumed. Nissan is by far the largest fallen angel of 2022 and 2023 combined, followed by Las Vegas Sands (3.32% added in June, 2022), adding 8.06% to the fallen angel index and boosting the auto sector exposure to approximately 18%. First Republic Bank was downgraded to junk by S&P and Fitch on March 15 and by Moody’s on March 17, reflecting the pressure on the company following SVB’s collapse earlier in March. The two subordinated bonds entered the index at a par weighted average of $54.63, adding only 0.40% of the index market value. Both bonds were trading in the mid-high 70’s prior to the SVB collapse.

Source: ICE Data Services, VanEck. Past performance is no guarantee of future results. Not a recommendation to buy or sell any of the names/securities mentioned herein.

Rising Stars: A total of three rising stars in the first quarter of 2023 exit the index. Western Midstream was upgraded to investment grade (to Baa3 from Ba1) by Moody’s on March 10 and, as expected, exited the index at March month-end. Western Midstream’s upgrade reflects a similar rating change to its primary customer and largest equity owner: Occidental Petroleum (OXY), although OXY still has an average rating of BB as Fitch and S&P still rate OXY as high yield. The most recent OPEC+ oil output cut and soaring oil prices could put OXY, alongside the other energy sector issuers, on investment grade status watch in the near term.

Source: ICE Data Services, VanEck. Past performance is no guarantee of future results. Not a recommendation to buy or sell any of the names/securities mentioned herein.

Fallen Angels Performance by Sector: Sector composition underwent major changes over the past month. With the entry of Nissan, auto exposure increased to 18.06% from 10.00%, and is now the second largest sector exposure, despite only having two issuers. Energy saw its largest exposure decrease since the April 2022 wave of downgrades, to 22.16%, as Western Midstream exited the index. Both sectors now dominate the index with a cumulative total at approximately 40%. The banking sector has a relatively low exposure (approximately 4%), but the possibility of additional downgrades is not negligible, as Moody’s placed another five regional banks on negative watch (in addition to First Republic), although none of these other banks have been downgraded yet. Some are still a few notches away from becoming high yield and there are relatively few index-eligible bonds among these issuers, so a major increase in banking sector exposure does not appear imminent. Within the banking sector, the index already held a Pacific Western Bank bond that was trading in the mid-90s in early February but has declined to high-60s in the last few days as a result of the mini banking crisis. As far as performance goes, all sectors, except for banking, posted positive returns for Q1. Banking was also the only sector that experienced a price decline (it was also the only one above par on February 28).

Source: ICE Data Services, VanEck. Fallen Angels: ICE US Fallen Angel High Yield 10% Constrained Index. 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 Rating: Lower rated bonds outperformed their higher rated peers, mostly due to an outstanding January. There were not many changes in the credit ratings of fallen angels for Q1.

Source: ICE Data Services, VanEck. 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.