Elevated Yields Spark Fallen Angels' Appeal

Fallen angels (as represented by the ICE US Fallen Angel High Yield 10% Constrained Index, “H0CF”) underperformed the broad high yield market (as represented by the ICE BofA US High Yield Index, “H0A0”) by 0.56% (-0.40% vs 0.16%) in Q4 and by 2.44% in 2024 (5.76% vs 8.20%) as lower duration and lower quality outperformed. The 10Y US Treasury experienced significant volatility in 2024, beginning the year at 3.88%, rising to 4.70% in late May, declining to 3.63% in early September then spiking in Q4 to finish the year at 4.58%. Early 2025 trends suggest yields moving closer to 5%, driven by persistent inflation and a strong labor market. Despite their underperformance, fallen angels continued to present a compelling long-term opportunity due to their oversold and undervalued nature.

Success Rates Matter: Fallen Angels vs Broad High Yield

Source: Morningstar, January 2004 – December 2024. Batting Average is measured by dividing the number of periods a portfolio or investment strategy outperforms a benchmark by the total number of periods.

2024 in Review

Rising stars outpaced fallen angels in 2024, but at a much lower pace than 2023. The fallen angel index had 5 fallen angels, adding approximately $6.4bn, while the 7 rising stars impacted approximately $9.7bn in market value. As expected, these figures were significantly lower than 2023, when they were approximately $19.9bn in fallen angels and $40bn in rising stars, but not in line with what was expected of more fallen angels than rising stars in 2024.

The Retail sector was most impacted by fallen angels, as Advance Auto Parts and VF Corp added approximate $3.4bn and Marks & Spencer’s upgrade removed about $315mn. Meanwhile, the upgrade of FirstEnergy reduced $3.8 billion from the Utility sector bringing the sectors’ weight to 2.22% versus 3.36% in the broad high yield index. The fallen angel index ended 2024 with Retail the largest exposure (22.15% vs 6.20%), followed by Telecom (12.56% vs 6.29%) and Real Estate (10.71% vs 4.36%).

Investors closely monitored inflation, labor market indicators and other economic growth indicators, as well as the potential policy impacts of the new administration, and continued to adjust expectations around U.S. Federal Reserve (Fed) policy. This has resulted in volatility in longer term bond yields, with the 10-year yield ending the year higher than where it started. Shorter-duration, lower rated credit outperformed due to limited duration risk and the risk-on sentiment that persisted through the year. Accordingly, certain structural characteristics of fallen angels (longer duration and higher quality) dampened relative performance compared to broader high-yield markets.

Credit spreads, which were thought to have limited room for tightening, trended downward throughout the year except for the short-lived whiplash in early August. Broad high-yield spreads tightened to post-GFC lows of 260bps in mid-November before ending the year at 292bps, below their 5-year and 10-year averages.

2025 Expectations

We expect the yield curve to continue to normalize, as long terms yields have risen while the market attempts to assess the potential impacts of tariffs, government spending and deregulatory agenda of the new administration, against a continued robust economic and employment backdrop. Policy rates will likely end 2025 somewhat lower, but the market is now only pricing in one 0.25% rate cut through the end of the year versus prior expectations of 250bps of cuts as recently as mid-September 2024.

Normalization of the yield curve could make bonds more attractive due to improved risk-return dynamics; as such, we will watch for changes in intermediate to long-term rates. Historically, fallen angels have offered better risk adjusted returns than the broad high yield market and overall yields continue to be incredibly attractive relative to historical levels. Fallen angels’ yield of 7.00%, is above the 1y, 3y, 5y and 10y averages, offering much higher quality than over the past 10 years.

There have been headlines about default rates and bankruptcies increasing, however, the majority of corporate balance sheets are still strong, especially in higher rated segments of the market. Much focus has been given to liability management exercises in the leveraged finance space, which is more relevant in the leveraged loan space than high yield corporates.

In terms of rating migrations, 2025 is expected to remain idiosyncratic, with no single sector at risk of widespread downgrades. However, policy uncertainty could introduce variability. JP Morgan Research stated that at the end of 2024, there was $699bn of BBB- rated debt, with 28% one rating notch from falling into high yield (Boeing and Warner Brothers, particularly). Bloomberg Intelligence writes that the majority of potential fallen angels are within Capital Goods (mostly Boeing) and Financials, in which they mentioned BDCs such as FS KKR Capital, BlackRok TCP and Oaktree Speciality Lending having a higher probability of downgrade.

Fallen Angels Overall Statistics: In 2024, fallen angels spreads tightened by 36bps, although, spreads were volatile reaching 310bps in August, but then tightening to 222bps by mid-November. The index spread remains approximately 200bps below the long-term average (commencing December 2003). The average yield of the fallen angel index finished the year relatively flat from the beginning of the year, while the yield of the broad market declined modestly. The market value of the fallen angel index decreased throughout the year, as there were more rising stars than fallen angels, but heavy issuance increased the broad high yield index market value. There were no fallen angels issuer defaults in 2024, while broad high yield had 6 issuers default, for a combined $4,144m in par value.

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: Prospect Capital Corp, a publicly traded BDC, was downgraded by S&P to BB+ from BBB- as it reported losses on its investment portfolio and cut its dividend. With Prospect Capital’s downgrade, there were a total of 5 fallen angels in 2024, adding 11% to the market value.

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: There were no rising stars in December, but there were 7 issuers upgraded to investment grade from high yield over the course of the year, removing approximately 16% of market value.

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: All sectors registered positive returns for the year, with Consumer Goods taking the lead at 11.83%, while Tech/Electronics had the lowest return at 2.04%. Throughout the year, the Retail sector saw an increased in exposure with the downgrades of Advance Auto Parts and V.F. Corp, while Utility and Energy sectors saw their exposures decrease. In terms of sector attribution vs broad high yield, Telecom, Banking and Consumer Goods contributed positively while all other sectors detracted from performance, with the lack of Media having the largest impact. Real Estate continues to be the only sector with a notably wide spread (at 450bps), demonstrating that concerns in the commercial real estate are still ongoing.

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: There were no significant changes in the fallen angels rating allocation throughout the year. Relative to the broad high yield market, BB-rated fallen angels outperformed its peers in the broad high yield market, but the below-BB rated issuers (Single-B and CCC and lower rated) detracted. The Single-B Index posted 7.55% and the CCC & Lower rated index posted an impressive 18.18% calendar year return vs flat and -1.86% return for the fallen angels in their respective rating buckets.

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. *Doesn’t have securities for all months of selective periods. Returns are based on partial period data.