High Quality Fallen Angels Should Provide Support for 2nd Half

The ICE US Fallen Angel High Yield 10% Constrained Index (“Index”) outperformed broad high yield (HY) by 0.13% (-6.67% vs 6.81%) for June. Fallen Angels have come out on top over the last two months but are still behind 2.73% on the YTD figure (-16.77% vs -14.04%). The main culprit of the underperformance was duration, with interest rates rising as the Fed tries to fight inflation. Despite a shortening of fallen angel duration due to rising stars leaving the index and a lack of new fallen angel volume, the segment has been more impacted than broad high yield, which has a shorter duration due to the nature of high yield bonds (issued with a much shorter duration that investment grade bonds).

The first half of 2022 has seen the worst start for fallen angels in years, and, unlike a few months ago, spread levels are now much closer to long-term averages. From that perspective, there could be opportunities to add exposure at more attractive levels. However, with consensus expectations for a growth slowdown or recession on the horizon, the potential for even wider spreads remain, even if the rate outlook may become more favorable. Compared to a broad high yield exposure, however, we believe fallen angels may outperform in such an environment given significantly higher weighting towards higher quality BB-rated bonds, which may outperform lower rated bonds in periods of volatility.

US Treasury Yield Curve

Source: US Treasury as of 6/30/2022. Past performance is not a guarantee of future results.

Monthly Fallen Angels Price

Fallen Angels started the year at $110.07 and dropped to $88.47 as of the end of last month, which is below the historical average of $95.82 (since December 2003). At $88.47, we are not far off from the COVID selloff in March 2022 where the price hit $83.30. Prior to COVID, prices were last near these levels in 2016 when the fallen angel price hit $84.01 as energy issuers were being downgraded at record pace following a collapse in the price of oil.

To add context, there have been 9 instances since December 2003 where the current price crossed from above the historical average price. Typically, the year after prices crossed, fallen angels have outperformed broad HY by 3.05%. Over the course of the following 3 years, outperformance has been 8.78% and it becomes wider over the following 5 years, 17.60% (in price terms). The last time the fallen angel price mean reverted and crossed the historical average was 4/30/22. It is important to point out, however, that prior price declines were typically associated with increased downgrades and new fallen angels entering the index at depressed prices. The current decline has so far been driven by interest rate increases, and characterized with very few fallen angels.

Cross Through Historical Average Price

Source: ICE Date Services and VanEck as of 6/30/2022. Past performance is not a guarantee of future results.

Monthly Fallen Angel 10 Year Spread

Spreads (option-adjusted spreads “OAS”) widened from 211 at the end of last year to 435 at the end of last month, more than 2x. The fallen angel OAS is now above the 10 year (383), 5 year (354) and 3 year (361) average indicating the potential opportunity to add exposure at historically favorable levels. This is just shy of the average from December 2013 (not shown below), which is 469.We need to remember that for about 2.5 years in the GFC, the spread was far above the 469 average. In recessionary periods, or simply periods with slowing growth, fallen angel spreads have typically reached at least 700 bps or much higher, with the most recent COVID recessionary selloff peaking at 954bps on a daily basis.

As such, if the economy is heading towards a hard landing, high yield investors should remain cautious, even at these current levels. At the same time, stressed spread levels would likely indicate a turn in the credit cycle, which has historically benefitted fallen angel investors. Timing, however, is impossible to predict and we see a far horizon given the currently low level of fallen angel candidates.

Historic Spread Levels

Source: ICE Date Services and VanEck as of 6/30/2022. Past performance is not a guarantee of future results.

Monthly Fallen Angels 10 Year Yield to Worst

The yield-to-worst for fallen angels started the year at 3.42 and by 6/30 fallen angels were yielding 7.43. Overall, yields have jumped (see US Treasury Yield Curve chart above), but fallen angels have indeed seen a significant leap in the YTW driven by both spread widening and higher interest rates. The current level is far above the 10 year (5.52), the 5 year (5.35) and the 3 year (4.94) average. It is even above the average from December 2013 (not shown below) which sits at 7.06.

Other periods where the YTW was above the long-term average of 7.06 (ex GFC) include COVID (March 2022: 8.33), Q4 2018 (December 2018: 7.43), 2016 energy downgrades (February 2016: 8.74) and Q4 of 2011 (European debt crisis: 8.00). In these prior periods, interest rates generally moved lower and higher overall yields were driven by much wider spreads, in contrast to the current period where rising interest rates has been a key driver.

10 Year Yield to Worst

Source: ICE Date Services and VanEck as of 6/30/2022. Past performance is not a guarantee of future results.

Fallen Angels Overall Stats

As mentioned above, yields are high. Both fallen angels and broad high yield percentage change was the same for the second quarter of 2022. Fallen angel duration keeps shortening, alongside the market value. It is worth noting that the duration of fallen angels has declined by more than 1-year to 5.7, whereas broad high yield has extended to 4.45, significantly narrowing the difference versus the beginning of the year. Fallen angels are therefore less exposed to rising rates at this point, as well as widening spreads, than they were one year prior. At the same time, if rates do begin to decline, fallen angels will benefit more than the broad high yield market from a duration perspective.

Source: ICE Date Services and VanEck as of 6/30/2022. Past performance is not a guarantee of future results.

New Fallen Angels

The first fallen angels of the year occurred during Q2. Steelcase’s price dropped ~14% over the last 6 months before joining the index and Las Vegas Sands’ price dropped ~12%. Steelcase was downgraded by S&P due to increased industry risks and weaker metrics after posting weak operating results for its year-end. Fitch downgraded Las Vegas Sands as they have limited confidence in the recovery of Macau's gaming industry due to very strict governmental COVID policies and their recently reduced economic forecast for China.

Source: ICE Date Services and VanEck as of 6/30/2022. Past performance is not a guarantee of future results. This is not a recommendation to buy or sell securities mentioned.

New Rising Stars

There were 2 issuers that were upgraded to investment grade over Q2. Michael Kors upgraded for April month-end and HCA for May month-end. Michael Kors was part of the 2020 downgrades, entering the index in April 2020 at $78.17 and posting a ~25% price return since index entry. However, over the last 12 months in the fallen angel index, it posted ~-8% price return. HCA has been part of the index for quite some time now, entering back in Q1 of 1998. Over the last 12 months in index, HCA price returned ~-11%. With these upgrades, the fallen angel index has now seen a little over 15% of its market value be upgraded to investment grade.

Source: ICE Date Services and VanEck as of 6/30/2022. Past performance is not a guarantee of future results. This is not a recommendation to buy or sell securities mentioned.

Fallen Angels Performance by Sector

Q1 saw major changes in terms of sector allocation as Kraft, about 10% weight, was removed from the consumer goods sector and the energy sector saw a bump to over 30% weight. On the other hand, Q2 was stable with few changes. With the addition of Las Vegas Sands to the index at a 3.32% weight, Leisure saw its allocation jump to 7.58%. Overall, spreads widened significantly more in Q2 than Q1 and they have more than doubled since the beginning of the year. Prices have come down significantly over both quarters, although the fallen angel index price was close to 12% in Q2.

Source: ICE Date Services and VanEck as of 6/30/2022. Past performance is not a guarantee of future results.

Fallen Angels Performance by Rating

Higher quality within fallen angels significantly outperformed the lower rating buckets for Q2. The higher quality within fallen angels helped push them closer to broad high yield as broad high yield has lower allocation to BB (53%) and higher allocation to the B (36%) and CCC (10%) rated buckets. Most sell side shops prefer higher-quality balance sheetsas economic growth continues to slow down with BB rated issuers havingstronger ability to adapt to the transition to a later stage of the business cycle. We believe the higher quality tilt of fallen angels may provide a strong cushion against spread widening and volatility if growth concerns continue to grow.

Source: ICE Date Services and VanEck as of 6/30/2022.

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