Rising Rates and Fallen Angel Bonds

While rising rates are generally negative for rate sensitive asset classes like fallen angel high yield bonds, the reason behind the latest rate moves may provide support for fallen angels. Historically, the fallen angels index¹ has provided positive returns and outperformance vs the broad high yield index² in most rising rate periods. Higher rates reflect expectations for stronger growth, which is generally positive for high yield bonds. The fallen angels index, in particular, may benefit due to a higher weight towards economically sensitive sectors which may have stronger participation in the ongoing economic recovery.

These factors have historically benefitted fallen angel returns, helping to overcome the impact of rising rates. Looking back at the 15 previous periods when the 10-year rates went up, there was only one—March 2004 to June 2004—in which the returns for the fallen angels index and broad high yield bonds index were negative.³ Although the longer duration of fallen angels has played a detracting role amid rising interest rates, on average the fallen angels index outperformed the broad high yield market index overall (returning 8.97% vs. 7.69%, respectively) over the 15 periods where the 10-Year rate rose.⁴ Over the most recent period, as 10-year yields rose from 0.52% to 1.75%, fallen angels returned 8.55% and broad high yield returned 7.14%.⁵

Rising Rates Historically Benefit High Yield and Fallen Angel Returns

Source: VanEck, ICE Data Indices, US Treasury

A Closer Look at the Most Recent Rising Rate Period

Source: VanEck, ICE Data Indices, US Treasury

Despite a rough March, when the 10-Year yield jumped 21% from 1.44% to 1.74%, the fallen angels index ended Q1 in positive territory, with underperformance vs. broad high yield index for the month mainly attributable to its longer duration.

The yield to worst of fallen angels index started the year at 3.80% and hit all-times lows in mid-February (3.60%). Since then, it increased along with rising interest rates and went above 4.00% in March, but ended Q1 at 3.91%. In comparison, the yield to worst of while broad HY high yield index barely changed from the beginning of the year. In Q1, the average duration of fallen angels decreased while broad high yield index duration has increased. As of March 31, the fallen angels index had a 6.70 duration to worst compared to 3.68 for broad high yield index.

Source: VanEck, ICE Data Indices

New Fallen Angel Bond

One fallen angel bond joined the index in March, adding ~$0.9B of debt to a total of $2.1B for the first quarter of 2021, bringing the total number of new fallen angels in Q1 to three. Over the six months prior to index entry, the price return for TechnipFMC was 0.65%, Hexcel Corp. -2.67% and Patterson-UTI Energy 24.64%. Prior to being downgraded, bonds are typically oversold as the market anticipates a rating action. Although on average this has resulted in price declines of downgraded bonds, the returns of TechnipFMC and Patterson-UTI illustrate that this is not always the case. These issuers’ price returns reflect the recovery in the energy sector from March 2020 lows.

Source: VanEck, ICE Data Indices. Past performance is not indicative of future results.

Rising Stars Emerge

Two rising stars exited the index in March. They joined Cenovus for the year, removing approximately $7.3B in debt from the index. Nordstrom entered the index not long ago (one of the many fallen angels in 2020), but Smurfit Capital has been in the fallen angel index since 2003.

Source: VanEck, ICE Data Indices. Past performance is not indicative of future results.

As we mentioned earlier in the year, rising stars have historically provided price appreciation over the 12 months before fallen angels are upgraded. Looking at this year’s rising stars so far:

• Cenovus returned 49% for the nine months it was in the index while broad high yield returned 13% during the same period.
• In the six months Nordstrom was in the index, it returned 25% vs. 4% for the broad high yield.
• Smurfit Capital was a different story. Smurfit Capital is a leading packaging company that generates a majority of its revenue from products that are sold quickly and at a relatively low cost, which was beneficial during the pandemic as people stayed home and had many items delivered to their doors. It only returned 3% while the broad high yield market returned 24%, although for context 12 months ago put us in March 2020, right at the bottom of COVID crisis. Longer term, the upgraded bond, which has been in the index since 2003, has outperformed the broad high yield market by more than 300bps per year over the past decade.

2021 Rising Stars

Source: VanEck, ICE Data Indices. Past performance is not indicative of future results.

Energy Sector Still Dominates Fallen Angels Index

The sector weighting for the fallen angels index remained fairly consistent throughout Q1. Fallen angels are still dominated by the energy sector, which outperformed the index during the quarter, as oil prices rallied sharply since the end of last year.

ICE US Fallen Angel High Yield 10% Constrained Index Sector Weighting

Source: VanEck, ICE Data Indices

Fallen Angel Bonds Credit Quality Remains Steady

Fallen angel bonds continue to provide a heavy tilt towards higher quality high yield bonds. At quarter-end, 94% of fallen angels were rated BB, the highest rating category within high yield. Lower rated bonds, however, performed best in Q1 as investors prepared for the economy to get back on track. These bonds usually pay higher coupons, which offer some protection against rising yields. They are also favorable when expectations for growth is high as defaults tend to be low.

ICE US Fallen Angel High Yield 10% Constrained Index Credit Quality

Source: VanEck, ICE Data Indices