Fallen Angels: Watching Sectors, Quality and Carry in 2024

Despite a resurgence in the fourth quarter, fallen angels (as represented by the ICE US Fallen Angel High Yield 10% Constrained Index, “H0CF”) lagged the broader high-yield market (as represented by the ICE BofA US High Yield Index, “H0A0”) by 0.22% in 2023, posting returns of 13.24% compared to 13.46%. The Q4 rebound can be primarily linked to the decline in U.S. bond yields by the end of December, which was accompanied by a sharp rally in credit spreads. Despite this late-stage recovery, the year-to-date underperformance of fallen angels was largely due to their limited exposure to lower quality bonds that offered higher carry throughout the year. The CCC & Lower rated index posted a return of 20.36%, the Single-B Index recorded 13.96%, and the BB index registered 11.44% for the entire calendar year.

2023 Returns

Source: ICE Data Services, VanEck. Past performance is no guarantee of future results.

According to Citi, credit ETFs experienced approximately $14.4bn in inflows while U.S. Government ETFs saw $5.9bn in outflows in December. High Yield corporate ETFs experienced another $4.3bn in inflows, matching November’s figure. There continues to be a shift into Intermediate and Long durations ETFs as they both attracted approximately $25bn, while Ultra-Short and Short duration strategies saw another month of outflows of approximately $5bn. These flows indicate a recent shift among investors towards adding credit and duration risk back into their portfolios.

2023 in Review: We were not off when writing last year that the 2023 story was going to be the U.S. Federal Reserve (Fed), spreads and rating upgrades.

In 2023, Fallen angels delivered a 13.24% return for the year, marking the 7th best performance in the last 20 calendar years. Over the past two decades, fallen angels have outperformed the broad high-yield market in 14 out of 20 calendar years, including seven out of 11 years with significant interest rate increases. However, they experienced underperformance in the last two calendar years, although they built some momentum over Q4.

Growth expectations and the impact on the yield curve were crucial, especially after the Fed's presumed pause in the second part of the year. Despite an inverted curve in 2023, signs indicate that the likelihood of a “soft landing” may have increased. Interestingly, the 10-year yield was flat for the year at 3.88% despite significant volatility, fluctuating between its lows of 3.30% in April and highs of 4.98% in mid-October. As the Fed Funds rate increased from approximately 0.25% to approximately 5.50% from March 2022 through July 2023, the 10-year yield changed by 1.65% (from 2.32% to 3.97%), with fallen angels underperforming by 1.17% (-1.76% vs -0.59%), driven largely by the higher interest rate duration of fallen angels. Fallen angel spreads were relatively flat throughout this period, increasing by just 18bps to 280, however, they oscillated between 248 (lows in April 2022) and 442 (highs in July 2022).

Rating migrations contributed to the fallen angel index market value decreasing to approximately $67bn. 14 rising stars, constituting 45.88% of market value, were removed while 13 fallen angels added 21.24% to the index market value. Sector exposures shifted significantly with Energy, Retail and Telecom now comprising the top-3 (42.14%) while the Auto sector was removed following Ford’s upgrade.

Although rating exposure remains concentrated in BBs at 81%, there was a small decrease from 87%; Single-B and CCC and lower-rated exposures increased to 19% from 13%.

2024 Story: Rate Cuts, Rating Migrations and Returns Post Fed Pause: The strong rally at year-end pulled some of this year’s total return potential into last year, and we believe further price appreciation from rates or spreads is limited for now. Accordingly, we expect returns to be driven primarily by carry. Relative performance versus broad high yield will likely be driven by quality and sector differences until we see a material impact from new fallen angels. We think the increase in Real Estate sector downgrades is notable and could continue, and there is potential for idiosyncratic downgrades in coming quarters.

Investors will continue to keep a close eye on the Fed and the timing of potential rate cuts. While the Fed indicated the likelihood of cuts in 2024 during their December meeting, the path forward is still uncertain, and rates will remain restrictive for some time. We anticipate continued scrutiny of data such as personal consumption expenditures (PCE), inflation, growth outlook, labor market indicators and unemployment rates before any adjustments are made. The market continues to price in more aggressive and faster rate cuts than what the Fed’s “dot plot” indicates, and upside inflation surprises or continued strength in wages and employment could result in sharp adjustments in market yields. We expect volatility to continue.

After the year-end rally in spreads (and rates), we see few catalysts for much lower levels. At the same time, it is hard to identify imminent drivers of significantly wider spreads, although we do expect some widening as corporate balance sheets slowly reflect the impact of higher funding costs. But that may take several quarters to materialize. We do not necessarily think long-term yields have much more room to decline based on current economic data. This year’s returns may generally be in line with current (and still historically elevated) yield levels, although we do anticipate bouts of volatility.

However, a sharper pivot than expected, either driven by an economic shock or geopolitical events, would likely be accompanied by a spike in credit spreads as recessionary concerns increase. In such a scenario, fallen angels could outperform broad high yield due to both their higher quality and the tailwind of a longer duration. A recession would also increase the likelihood of a meaningful increase in new fallen angels, which has historically been a driver of outperformance.

We expect a lower level of rising stars as the reversal of the 2020 downgrade wave appears to be behind us. Credit migration forecasts generally call for fallen angels outpacing rising stars in 2024. Despite the strength of balance sheets for high-yield issuers, there are signs of weakening fundamentals and a significant amount of investment grade debt on the cusp of high yield. Per JP Morgan, there was approximately $800bn of BBB- rated debt at the end of 2023 with approximately 23% one notch away from high yield.

Last, we looked at how HY has performed post a Fed pause and believe fallen angels are poised for positive returns as they are approximately 81% BBs, which tend to outperform the lower rated buckets on average, over the following 3 months, 6 months and 1-year periods. Since December 1996, the Fed has paused its hiking cycle on five occasions: March 1997, May 2000, June 2006, December 2018 and July 2023. On average, the pause lasted approximately 12 months which was then followed by a rate cut. During the year following a Fed pause, BBs have posted double digits three out of four times and have never posted a negative return.

Source: , ICE Data Services, VanEck. Past performance is no guarantee of future results.

Fallen Angels Overall Statistics: In 2023, fallen angels' yield declined by 46 basis points in December and 159 basis points from late October highs, ending the year at 6.99%. Spreads for both indices decreased, remaining approximately 175 basis points below their all-time averages. Duration for fallen angels decreased until Q4, when it increased due to the exit of Ford and the addition of Walgreens. Longer duration could potentially be advantageous if rates continue to decline. The market value of the fallen angel index increased in December, with the addition of the two new fallen angels. Broad HY saw another issuer default (ASP AMC) this past month. with $500m par outstanding, adding to 15 issuer defaults in 2023 accounting for approximately $16bn in par, compared to only just one issuer default in the fallen angel index (Bed Bath and Beyond) with $628m par amount in the index.

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 new fallen angels: Vornado Realty – the second REIT of the year – and Walgreens entered the index in December, making 2023 a year with 13 fallen angels and adding 21.24% to the index. Vornado Realty was downgraded by Moody’s to Ba1 from Baa3 in early December following Fitch’s downgrade in August, reflecting the challenges related to the leasing and financing markets. Walgreens was also downgraded by Moody’s to Ba2 from Baa3, reflecting its high financial leverage and the elevated risk that it faces as it implements initiatives to try and reverse the loss of its U.S. healthcare segment. The market value for all 13 issues was $21bn, which was double the 2022 and 2021 figures (approximate $10bn), making it a good year in terms of volume, however, it was overshadowed by the large number of rising stars.

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: No rising stars in December, but in 2023 there were 14 issuers, totaling 45.88% of market value, that were removed from the fallen angel index due to upgrades to investment grade. This figure was much higher than the previous two years, as 2022 saw only eight issuers (18.36% removed) while 2021 had 12 issuers (12.13% removed). The expectation for the new year is a much lighter pipeline for upgrades, as much of the rising star wave appears to be behind us.

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: All sectors registered positive returns for the year, with Telecom leading at 20.58% year-to-date, while Banking had the lowest return at 4.00%. Throughout the year, rating migrations reshaped the sector composition of the fallen angel index. Auto was removed from the index due to removal of Ford. Energy reduced its exposure from approximately 28% to approximately 15% due to several rising stars. Real Estate increased from approximately 5% to approximately 9% as two REITs were downgraded, making it a sector worth monitoring, given continued pressures in the commercial real estate sector. Retail now stands as the second-largest industry with a 14.38% exposure after Walgreens entered the index, while Telecom remains a substantial exposure. Real Estate is the only sector with a notably wide spread (greater than 500bps), reflecting continued concerns in commercial real estate. The index finished the year with an average price of $91.20.

Source: ICE Data Services, VanEck. ^*Does not have securities for all months of selected periods. Returns are based on partial period data. 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: In 2023, CCC-rated fallen angels outperformed its higher rated peers, posting a 33.88% return, followed by Single-Bs (15.52%) and BBs (12.19%). Broad HY saw comparable results with lower quality high yield bonds outperforming its highly rated peers which, with a higher exposure, outperformed fallen angels for the year. We are keeping an eye on Single-Bs, as the price is above its all-time average of $92.28.

Source: ICE Data Services, VanEck. ^*Does not have securities for all months of selected periods. Returns are based on partial period data. 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. BB index: ICE BofA BB US High Yield Index; Single-B index: ICE BofA Single-B US High Yield Index; CCC & Lower rated index ICE BofA CCC & Lower US High Yield Index.