Fallen Angels: Outperformance After Fed Cuts

Fallen angels (as represented by the ICE US Fallen Angel High Yield 10% Constrained Index, “H0CF”) outperformed broad high yield (as represented by the ICE BofA US High Yield Index, “H0A0”) by 19bps in July (2.15% vs 1.96%), reducing the YTD underperformance to 1.37% (3.26% vs 4.63%). Both strategies performed similarly until the last day of the month when fallen angels posted a gain of 0.48% vs 0.23% for high yield. This difference occurred as the U.S Federal Reserve (Fed) left rates unchanged but indicated confidence in disinflationary trends, which was interpreted by the market as dovish and resulted in an increase in the implied probability of a September rate cut. Long term Treasury yields declined gradually through the month, resulting in longer duration assets outperforming as shown in the chart below. But the decline began to accelerate in the last week – particularly on the day of the Fed meeting – perhaps reflecting concerns that the Fed may have kept the policy rate too restrictive for too long. In addition, after hitting their tightest level since December 2021 on July 23, high yield bond spreads began widening through the last week of the month. This view of a potential “hard landing” found further support at the end of the week with weak economic data, particularly related to employment, resulting in a sharp decline in bond yields, but also a significant widening in credit spreads. Whether this is indicative of a recession and the start of a more significant widening cycle in credit remains to be seen, but it’s worth noting that despite a sharp increase in spreads through August 5, high yield bond spreads remain below their 10-year average. With higher volatility, valuations that remain historically high and increasing concerns about economic growth, we believe the case for higher quality exposure is particularly strong right now for high yield investors.

Rate Cut in Sight?

As mentioned above, the probability of a September rate cut has significantly increased over the past few days. With that in mind, we examined the performance of fallen angels and broad high yield bonds during the last two periods when the Fed lowered rates—September 2007 and August 2019—to understand how fallen angels have historically behaved in rate-cutting cycles. Fallen angels outperformed broad high yield over various time periods following the first rate reduction (see chart below), with spreads widening over the following months after the first cut as the economy experienced a slowdown/recession. Note that those cuts occurred under varying economic and market conditions, but we believe that the in current cycle, the higher quality and differentiated sector exposure may be drivers of outperformance going forward, as they have in the past.

Historically, Fallen Angels Have Outperformed Broad HY After Fed Rate Cuts

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

We also analyzed performance from the last hike to the first cut and from the last hike to the last cut. In both cases, fallen angels outperformed by an average of 0.80%. From the last hike to the first cut (June 2006 to September 2007 and December 2018 to August 2019), both strategies posted double-digit returns, with fallen angels leading by 0.71% on average. In contrast, from the last hike to the last cut (June 2006 to December 2008 and December 2018 to March 2020), broad high yield posted negative returns in both periods, while fallen angels achieved positive returns in the latter period.

Fallen Angels Overall Statistics: Fallen angels yields decreased by 29bps to 6.81% in July, the lowest this year, while the fallen angels price jumped to $91.90, the highest it has been since February 2023 when it reached $92.06. Broad high yield saw similar changes, with yields decreasing 33bps and its price increasing to $94.37, which is just $2.28 below its average since December 2003. The move down in yields/jump in prices reflected the 10-year U.S. treasury rallying 27bps in July and finishing at 4.09%.

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.

Fallen Angels: No fallen angels in July.

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.

Rising Stars: Delta Air Lines was removed from the index in July (1.5% exposure), as it was upgraded by Fitch to BBB- from BB+, reflecting improved credit metrics post-COVID-19 pandemic. Fitch joins Moody’s as the two agencies rating Delta as investment grade, while S&P still rates it as high yield. Delta entered the fallen angel index in April 2020, at the peak of the pandemic, with a par weighted price of $80.59 and exits at $94.59, while broad high yield saw it prices change to $94.37 from $89.09. Rising stars have accounted for 15% of the index market value so far this year.

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: The exit of Delta Air Lines reduced the index’s exposure to the Transportation sector to 1.10%. Energy, Retail and Telecom sector weights increased slightly. In terms of performance, all sectors except for Retail, the largest exposure at 19.39%, posted positive returns in July with Telecom and Real Estate having the highest returns. Prices, in general, increased as yields decreased throughout the month. Comparing fallen angel vs broad high yield performance, Telecom and Real Estate were also the top contributors to outperformance with both fallen angel sectors being overweight 2.2x and 2.4x, respectively, while still posting higher returns. Retail and Media (no exposure) were the top two detractors, with Walgreens being the main culprit in Retail as fallen angels were significantly overweight (spreads widened by 39bps in July).

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.

Fallen Angels Performance by Rating: The rating exposure remained stable with BB-rated bonds still dominating fallen angels at approximately 87% exposure. The higher quality of fallen angels continues to offer a compelling case for those investors looking for higher yields and lower volatility, as broad high yield exposure to BB-rated bonds is just 53%. The six issuers that represent the CCC and CC rated buckets in fallen angels outperformed their higher rated peers, but when compared to the broad high yield, the BB-rated bonds were the top contributors to July’s outperformance. The +120% return in Embarq Corporation (the only issuer rated CC) also contributed, but to a lesser degree due to its small exposure.

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.