Why Fixed Income’s Fallen Angels Fly High

Fallen angel bonds represent an often overlooked part of the fixed-income market. They are corporate bonds that were originally issued with investment grade status and were then downgraded to high yield by credit rating agencies. Over time, fallen angel bonds have consistently delivered higher returns than other high yield bonds.

For many years, this might have seemed an interesting anomaly that did not tempt many investors away from equity markets. Yet with interest rates in the US and Europe looking like staying higher for longer, fallen angel bonds are flying high. Our VanEck US Fallen Angel High Yield Bond ETF, for instance, has an income yield of more than 7.5% (note that it accumulates the yield rather than paying it out).

So, what exactly is fallen angel fixed income? In short, fallen angels are bonds that had an investment grade credit rating before being downgraded by credit rating agencies due to the declining creditworthiness of the companies issuing them. They include major companies like Vodafone, Royal Caribbean Cruises and Nordstrom.

The recent launch of our VanEck US Fallen Angel High Yield Bond UCITS ETF complements well our offering of fallen angels, which includes already a global version. This latter seems to be more appropriate for investors who aim at achieving higher diversification, since it includes bonds from several countries and with many currency denominations. The latest launch instead focuses on the US and can be attractive especially for those investors wanting to have separate fixed-income allocations in terms of currency¹.

At VanEck we leverage more than 10 years of experience in fallen angels investing, with the strategy offered in the US counting assets under management in excess of $2bn.

Averaging Higher Returns

It’s a well-known anomaly that fallen angels have historically delivered higher average returns than other high yield bonds. For instance, over the 20 years or so from the end of 2003 to the end of June 2023, the ICE US Fallen Angel High Yield 10% Constrained Index generated a total return of 367.9%. This compares with 225.4% for the ICE BofA High Yield Index².

What’s more, the fallen angels’ outperformance was pretty consistent. In other words, the fallen angel index has outperformed the high yield index in 14 of the last 20 calendar years (see below).

Calendar Year and YTD Returns (31/12/2003 – 30/06/2023)

Source: FactSet. Data as of 30/06/2023.

Why might that be the case? Largely because financial markets tend to think ahead, anticipating outcomes. Indeed, investors often easily see when credit rating agencies are about to downgrade bonds. As many can only hold investment-grade bonds, they sell ahead of the downgrade, meaning that the bonds are often over-sold when the downgrade actually occurs.

Naturally Contrarian

But fallen angel bonds have tended to have a higher credit quality on average than the broad high yield universe, and they are naturally contrarian because companies’ finances tend to deteriorate at times when the sectors they are in come under pressure. The colourful chart below of sector weightings in the ICE US Fallen Angel High Yield 10% Constrained Index illustrates the point: following the 2008 financial crisis the weighting in bank stocks ballooned, a similar thing happened with energy stocks after the 2015 oil price crash, and then again with automotive stocks following the Covid-19 2020 lockdowns when car sales plummeted.

ICE US Fallen Angel High Yield 10% Constrained Index

Historical Sector Allocations (31/12/2003 – 30/06/2023)

While fallen angel bonds have fairly consistently beaten the returns from their high yield peers, what’s changing now is that their yields compare favorably with the historical returns of equities. The bond market as a whole did not have such high yields during the long decade or more of low policy rates from 2010. However, the fast rate hiking cycle of central banks in response to inflation has changed the picture, with yields now at much more interesting levels.

But it seems like those days of low policy interest rates were the anomaly. While rates will undoubtedly fall back at some point, most observers think they are unlikely to touch the extreme lows previously seen. All of which means that fallen angels should continue to fly reasonably high.