Fallen Angels Index Shift Looms as Potential Entrants Emerge

After outperforming in Q1 by 0.10%, fallen angels (as represented by the ICE US Fallen Angel High Yield 10% Constrained Index, “H0CF”) underperformed broad high yield (as represented by the ICE BofA US High Yield Index, “H0A0”) by 1.60% in Q2 and now lag by 1.53% YTD. Most Q2 underperformance can be attributed to credit deterioration in weaker credits within the Telecom and Real Estate sectors. Within Telecom, Embarq had been trading at distressed levels all year but deteriorated further in June following a downgrade. In addition, Lumen Technologies spreads widened significantly through the quarter. Within Real Estate, Office Properties Income Trust, a REIT focused on office properties, conducted a distressed exchange, reflecting ongoing concerns in that sector. Fallen angels continue to be overweight to the Real Estate sector by approximately 2.5x versus the broad high yield market. Rates have also taken a toll on fallen angels this year, as intermediate and long maturity US Treasury yields have increased approximately 0.50%, most of which occurred in Q1.

What Lies Ahead for the Remainder of the Year?

J.P. Morgan is expecting fallen angels to outpace rising stars for the remainder of the year, with approximately $30bn downgrades expected and only $5bn in rising stars. The downgrades are expected to occur within Media, Basic Industry, Retail, among others, and are mostly idiosyncratic in nature. One of the issuers, Paramount, is already rated high yield by S&P (BB+), while Fitch has it on negative watch (BBB-) and Moody’s put its Baa3 on review for downgrade after it agreed to sell itself to SkyDance due to ongoing pressures that will continue to impact the businesses. Below we analyze how Paramount would impact the fallen angel index, if it were to be downgraded to high yield:

• The fallen angel index hasn’t had exposure to the Media sector since the middle of 2019, and Paramount would be the only issuer in the sector.
• With approximately $13bn in debt, Paramount would likely reach the index’s 10% issuer cap, making it the largest exposure in the index. The largest exposure now belongs to Walgreens with just over 6% weight in the Retail sector.
• Paramount’s duration is slightly longer than 7 years, which would increase the fallen angel index duration.
• Over the last 6 months, the average price return of Paramount bonds in the broad investment grade index was -8.25%.

Paramount Par Weighted Price (last 6 months)

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

Fallen Angels Overall Statistics: Fallen angel yields decreased by 20bps in June to 7.10% but remain elevated vs Q1 and the end of last year, while spreads continue to trade rangebound in the mid-200s. Broad high yield saw similar changes, with yields decreasing 10bps but still above the end of Q1 and spreads experiencing minimal changes. After hitting 4.70% in May, the 10-year U.S. treasury yield ended June at 4.28% amid a benign CPI/PCE reports, unemployment ticking up slightly above 4% and the median Fed calling for a 0.25% cut by the end of this year. Minor changes in the fallen angel index have brought duration slightly down while the broad yield duration has been muted. Regarding defaults, the broad high yield market saw Petrofac default in June ($600 million par outstanding), adding to 5 issuers that defaulted in Q1 for a total of $4,144m vs $0 for fallen angels.

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 strategy performance. It is not possible to invest in an index.

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 strategy performance. It is not possible to invest in an index.

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 strategy performance. It is not possible to invest in an index.

Fallen Angels Performance by Sector: No major change in the sector allocation over the past few months due to the lack of fallen angels and rising stars. In terms of performance, all sectors except for Financial Services, RE, Retail and Telecom (approximately 43% exposure) posted positive returns in June, with Healthcare and Tech being the top performers, although their contribution to return was limited due to their relatively low exposure (approximately 12%). In terms of attribution vs broad high yield in June, the impact of wider spreads was the main culprit of the underperformance by fallen angels especially within Telecom, with two issuers (Embarq and Lumen Technologies) seeing their spreads widened to +5000bps and +2000bps respectively. Within Real Estate, Office Properties Income Trust (OPI, 0.83% exposure) conducted a distressed exchange and was removed from the index due to not meeting index minimum face amount outstanding requirements. Within Retail, Walgreens (6.29% exposure) spreads widened by close to 80bps. The idiosyncratic nature of these events has affected their price, especially in Real Estate and Telecom, but with the exit of OPI and the now low weightings of Embarq and Lumen Tech (0.49%), further downside in these names is limited.

Source: ICE Data Services, VanEck. 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 strategy performance. It is not possible to invest in an index.

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 strategy 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.