Fallen Angel Bonds: Consistency Is Key

Fallen angel high yield bonds¹, which are originally issued with investment grade ratings, have exhibited a remarkably consistent history of outperformance vs. the broader high yield market² over the long-term. For example, out of the last 17 full calendar years, fallen angels bonds have outperformed in 13. This period encompasses many different market environments: rising and falling rates, recessions and expansions, and credit spreads at both extreme highs and lows and everything in between. What has remained consistent is the strong absolute and relative returns of fallen angel bonds, driven by three key sources of return: systematically buying oversold bonds at deep discounts, a contrarian sector exposure, and a higher quality tilt versus the broad high yield market. These return drivers are fueled by the unique characteristics of fallen angel bonds, which set them apart from the broader high yield market, and a result of structural characteristics and differences between the high yield and investment grade markets. The result has been a differentiated stream of returns compared to both the broad high yield market and other high yield strategies.

Fallen angel high yield bonds have continued outperforming the broad high yield market in Q3, increasing overall year to date outperformance. Fallen angel high yield bonds returned 1.68%% vs 0.94% for broad HY bonds during the last three months, expanding the YTD figure difference to 1.91% (6.59% vs 4.68%) as of September 30, 2021. Most of the outperformance in Q3 came from the energy sector. The number of fallen angel bonds outnumbered rising stars in September, but going forward, we expect the broader theme that we have seen this year to remain the same: rising stars will continue to outpace fallen angels in the coming months, as most of the credit measures are expected to continue improving due to improved economic growth and market conditions. The benign credit environment and improved funding conditions are reflected in HY issuance, which has skyrocketed compared to the same time period last year as detailed by SIFMA (HY nonconvertible issuance is up 28% vs 2020, as of August month-end). HY issuers have been strengthening their balance sheets by rolling over debt at much lower rates and longer maturities.

Fallen Angel Bonds Index vs. Broad High Yield Bonds Index: Returns in 2021

Source: VanEck, ICE Data Services. Data as of 9/30/2021.

There are three important questions we want to highlight in this note: 1) Where we are in terms of the upgrade cycle and 2) the current spread environment, and 3) how does rising yield affect fallen angel bonds?

Where Are We in Terms of the Upgrade Cycle?

This year there have been more upgrades, in terms of percentage of market value to the fallen angel index, than downgrades so far. Why? Credit trends have improved with the strong economic recovery, resulting in very low default rates, higher chances of issuers of being upgraded and lower risk (other than on a limited-idiosyncratic nature) of downgrades to high yield. Ratings agencies and sell-side research desks continue to believe that there will be a growing number of rising stars within the next few years. Given that the number of actual issues upgraded from HY to IG has been limited so far in 2021, we believe that we are in the early stages of the upgrade cycle.

Predicting the timing of rating agency actions is difficult. Historically they have tended to lag the market, but there have been instances where they surprised the market and acted quickly, such as in 2020. With that said, we believe more upgrades are coming, though there are still risks to this outlook, including COVID, which is still here despite all efforts. However, in our minds the current trend is clearly positive and fallen angel bonds stand to benefit as rising stars could emerge again. These bonds have outperformed the broad high yield market by approximately 700 basis points, on average, in the 12 months prior to credit rating upgrades.

Taking a step back, it can be useful to consider this expected source of return – upgrades to investment grade – in the context of a typical credit cycle to understand why fallen angels have been able to historically provide consistent outperformance relative to the broad market. The below chart provides a stylized representation of the various stages of the credit cycle, and the characteristics typically associated with them. It also lists the three sources of return that have driven the differentiated performance of fallen angels historically, and which are likely to dominate in a given stage of the cycle. Last year was undoubtedly characterized by an unusually compressed cycle, where we saw contraction, trough and the beginnings of a sharp recovery. Overall, new fallen angels drove performance through the trough, while contrarian sector exposures (primarily overweight’s to cyclical sectors such as energy) provided a boost as the recovery began.

So, where are we based on our chart? Probably somewhere between Expansion/Peak, as we are seeing low defaults, low fallen angels and the beginning of the rising stars. With credit trends expected to continue to remain strong, rising stars are likely to continue to shine for the foreseeable future. Given current tight spread levels, the higher quality tilt that drives a higher exposure to potential rising stars may also protect against any stint of volatility and spread widening. We also expect sector exposures to continue to be a driver of differentiated performance, given the continued economic recovery that is not expected to be derailed by an overly aggressive Federal Reserve (Fed) anytime soon.

Source: VanEck.

The Current Spread Environment

Tight. One word that describes where all spreads sit right now. Going back all the way to December 2003, the average OAS³ for broad high yield is 527, and we are currently at 315.⁴ Average for BBs⁵ (360), single-B⁶ (525) and triple-CCC⁷ or below (1015) follow the same pattern vs current spreads: 218, 364 and 654 respectively. Fallen angels spreads are also tight. However, as we’ve described before, they’ve shown consistent outperformance through the credit cycle.

What does that mean? We believe there are two ways to look at this:

1. How fallen angels perform over tight spread environments (tight spreads meaning that the OAS is below its average). There have been 5 periods (since 2003) when that has been the case, and in all 5 periods, fallen angels have come out on top of the broad HY. The latest period started more than a year ago (July 2020), with fallen angels outperforming by 5.56%. On average, these periods of tight spreads have lasted approximately 28 months and fallen angels outperformed the broad high yield market by 4.67%.

Fallen Angel Bonds Index in Tight Spread Environments

Source: VanEck, ICE Data Services.

2. The other way to approach the current environment is identify a strategy that has consistently outperformed the market rather than focus on absolute spread levels. One measure used to identify that strategy is to look at “batting average,”⁸ which, to the non-baseball fans, is a measure that indicates how often an investment strategy has outperformed a benchmark. We looked at how fallen angels have done vs the broad HY since the index inception⁹ without looking at credit cycles, spreads widening or tightening, defaults, downgrades or upgrades, etc. The result since 2003 is consistent outperformance over time:

Fallen Angel High Yield Bonds Index Batting Average vs Broad HY Bonds Index

Source: VanEck, Morningstar.

How Does Yields Rising, Again, Affect Fallen Angel Bonds vs. Broad High Yield Bonds?

Rates are rising again, but this is similar to what occurred back in Q1, when the 10Y rose 0.81% from 0.93% to 1.74%, which is the highest reported figure this year. During that period, fallen angels outperformed broad high yield by 1.41% (8.55% vs 7.14%). Rising yields impact long dated bonds to a greater extent, and fallen angels do have an average duration that is longer than the broad high yield market. But the different sources of returns keep paying off. Back in April, we looked at the 15 previous periods when the 10-year rates went up, finding only one providing negative returns. Since then, a new period started mid-July of this year when the 10Y hit 1.19%, with fallen angels still up by 0.21% (1.45% vs 1.25%) as of September month-end. Below is a closer look at the two most recent rising rate periods in which fallen angels have continued their course of outperformance despite a higher average duration than the broad high yield.

Fallen Angel Bonds Index vs. Broad High Yield Index Amid Rising Rates

10Y vs Fallen Angels vs Broad HY

Source: VanEck, ICE Data Services.

Fallen Angels Overall Stats: Yield to worst for fallen angels ended the quarter relatively flat vs. Q2. However, over the last weeks of September, it rose 20bps to end the quarter at 3.36%. Rising stars and, to a greater extent, tenders offers have driven the decline in total market value of the fallen angel universe, while overall HY issuance has remained strong this year.

Source: VanEck, ICE Data Services.

New Fallen Angels: Four new fallen angels entered the index for September month-end adding ~$6.5bn of debt to the index. The Nordstrom downgrade to HY is more of a technicality as Fitch reinstated their BBB3 rating earlier in the year. It was upgraded to investment grade, but then Moody’s downgraded it earlier in September to high yield, thus why you will see Nordstrom in both the new fallen angels and new rising sectors below. Something similar occurred with Genting NY, which changed country of risk from Malaysia to the U.S. With that said, the index bought Nordstrom back at a $0.05 discount vs. what it sold at back in March. Perrigo Finance, Genting NY and Domtar Corp. price action over the last six months before downgrade were: +1.72%, -0.57% and -16.82%, respectively.

Source: VanEck, ICE Data Services.

New Rising Star: One issuer–EPR Properties–left the index in September after being downgraded back in October 2020, removing ~$2.4bn of debt. Over its 11 months in the fallen angel index, EPR Properties outperformed the broad HY market by 12.84%.

Rising Star EPR Properties Outperformed Broad High Yield Index

EPR Properties vs Broad HY
October 2020 - September 2021

Source: VanEck, ICE Data Services.

Fallen Angels Performance by Sector: The Healthcare and Retail industries saw an increase of over 1% in weight during Q3 as Perrigo and Nordstrom joined the index and Real Estate lost over 1% after EPR Properties’ upgrade. Energy keeps first place in terms of returns for the quarter, but it still has a lower price than the index indicates, which means that there may still be more room to run.

Source: VanEck, ICE Data Services.

Fallen Angels Performance by Rating: Fallen angels have kept its high exposure to BB-rated bonds and it appears that it will stay like this for some time. The CCC bucket outperformed over Q3, as investors are still looking for yield, and so far, it has been paying off.

Source: VanEck, ICE Data Services.