Revisiting Performance Through Tight Spreads

In February, 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 0.70% (-0.40% vs 0.30%). Year-to-date, fallen angels are behind by 0.14%, posting returns of 0.17% versus 0.32% for the broad high yield market.

During the same period, lower-quality assets outperformed their higher-rated counterparts, and short-duration investments outpaced long-duration ones. This trend coincided with a 0.26% increase in the 10-year yield, reaching 4.25% by the end of February. The strong rally in risk-assets that began in the fourth quarter continued through February, which has resulted in tight spreads in all credit asset classes. High yield bond spreads are not far from their post-COVID spreads while high overall yields have continued to attract investors, despite these tight spread levels.

Revisiting Performance Through Tight Spreads

In our 2021 outlook for fallen angels, we extensively covered their performance in tight spread environments, marked by a downtrend from the elevated levels observed in March 2020, when both fallen angels and broad high yield stood at around 1000bps, to the mid to low 300s. By October 2021, fallen angels spreads reached their all-time lows at 200bps, while broad high yield saw spreads hit 301 bps, approximately 60bps wider than their previous all-time lows in June 2007 at 241bps.

Currently, we find ourselves in a situation with similar spread levels, where fallen angels have spreads at 260bps and broad high yield stands at 329bps. It is noteworthy that this similarity in spread levels exists in vastly different economic environments. Historically, fallen angels have outperformed in periods of below average spread levels.

This has been driven by the fallen angel technical effect (price recovery or appreciation after bonds are downgraded to high yield), contrarian sector exposures and a higher average credit. These factors have collectively contributed to the resilience and potential for outperformance by fallen angels in periods where spreads remain below their long-term average for prolonged periods. With overweights to Retail and Real Estate sectors (which have increased, particularly exposure to commercial REITs) and an 82% allocation to BB rated bonds, compared to 50% for broad high yield, fallen angels may be positioned favorably.

Fallen Angels Outperformance Over Tight Spread Periods

Source: ICE Data Services, VanEck. Fallen Angels: ICE US Fallen Angel High Yield 10% Constrained Index. Broad HY: ICE BofA US High Yield Index. Index performance is not representative of fund performance. It is not possible to invest in an index. Past performance is no guarantee of future results.

Fallen Angels Overall Statistics: The yields on fallen angels recently surpassed 7%, while spreads experienced a tightening of 23bps over the past month, settling at 260bps. Although this level has not been observed since April 2022, it remains notably higher (60bps) than the lows recorded in October 2021 at 200bps. This trend persists due to ongoing resilient economic growth, better-than-expected earnings and elevated yields, with the 10-year yield rising to 4.25% from 3.99%. Given the sustained elevation in yields, we believe investors still have the opportunity to capitalize on higher yields, providing a potential cushion if spreads were to widen significantly. In terms of defaults, fallen angels have yet to experience any so far this year, in contrast to the broad high yield market, which saw another issuer, Cano Health (holding $300 million par outstanding), default. This brings the total defaults for the broader high-yield market to two for the year, thus far. The discrepancy in default rates emphasizes the relative resilience of fallen angels and higher quality amid the evolving economic landscape.

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 fund performance. It is not possible to invest in an index.

New Fallen Angels: In February, Advance Auto Parts (AAP) entered the index and added 2.52% to the Retail sector which now represents the largest exposure of the fallen angel index at 17.20%. AAP was downgraded by Moody’s to Baa3 from Baa2 as it expects AAP’s EBITDA margins to remain below historical levels, reflecting lower sales growth and gross margins with much higher expenses. Moody’s still rates the company as investment grade, but S&P had downgraded it to BB+ from BBB- in September 2023 due to weak credit metrics, as its sales were relatively flat while its competitors grew. Following the Moody’s downgrade, the average rating is high yield. The average price of AAP’s bonds six months ago was $89.17, and it entered the index at an average price of $91.20.

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 fund performance. It is not possible to invest in an index.

Rising Stars: The first rising star of the year is Las Vegas Sands (LVS), exiting the index at $93.19 (weight 3.12%) while joining the index back in June 2022 at $89.72 (3.32%), providing a 3.87% price return over the 20 months in the index. During the same 20 months, the fallen angel index price return was 2.10%. On February 1, LVS was upgraded by Fitch to BBB- from BB+, reflecting the strong rebound in Macao and outperformance in Singapore. LVS highlighted the growth in Macao during most of 2023 as all COVID-19 measures were dropped in the region, allowing for gamblers to come and go as they pleased with no capacity limits in their casinos. S&P was ahead of Fitch’s upgrade, as it upgraded LVS to BBB- from BB+ in July 2022 for very similar reasons: accelerating recovery in Macao's cash flows.

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 fund performance. It is not possible to invest in an index.

Fallen Angels Performance by Sector: Retail exposure jumped to 17% with the addition of AAP into the index, while the Leisure sector’s exposure was cut almost in half after LVS’ exit. Spreads tightened during the month, except for Basic Industry and Services, which saw their spreads widen by 25bps and 3bps, respectively, while all but the Financial and Retail sectors saw their prices increase. In terms of attribution relative to broad high yield, the underperformance was notably influenced by two of the largest sectors, Real Estate and Telecom, while the lack of Media exposure in fallen angels was a contributor.

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 fund performance. It is not possible to invest in an index.

Fallen Angels Performance by Rating: Within the fallen angel index, single-Bs outperformed BBs and CCCs, but we continue to pay close attention to the single-B price as the gap to BBs has increased due to the lower duration experienced by lower credits. There have only been two other times where the price of single-B fallen angels was much higher than BBs: January 2009 and March 2020.

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 fund 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.

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