The Consistency of Fallen Angel High Yield Bond Returns

After essentially completing a market cycle in just three quarters in 2020, high yield spreads are back below historical averages and yields are as low as they’ve ever been. High yield investors may be asking what might drive performance going forward, and how to navigate an environment characterized by both tight spreads and higher corporate leverage, as well as continued low rates in the face of higher economic growth. We believe that in this uncertain environment, high yield investors should be selective and focus on fallen angel bonds—which are bonds originally issued with investment grade ratings—as a potential source of outperformance relative to the broad high yield bond market. Fallen angels have provided outperformance in 13 of the last 17 calendar years, a level of consistency that we believe may be attractive in a changing market environment such as the one we are currently in.¹

Investors that focused on fallen angel high yield bonds were particularly well positioned for the massive $170 billion wave of downgrades that occurred last year. Fallen angels historically experience forced selling by investment grade investors ahead of a credit ratings downgrade, and are purchased at deep discounts, on average. That discount provides upside potential, and with the significant downgrade volumes, market volatility and risk aversion in the first half of last year, discounts were approximately twice the historical average.² Accordingly, the largest fallen angel issuers, including Ford, Occidental and Kraft, were among the biggest contributors to outperformance versus the broad high yield market in 2020. Although we don’t necessarily believe that this cycle of downgrades is completely behind us, we believe this wave has likely crested, and downgrade volume has already slowed dramatically.

Drivers of Fallen Angel Bond Returns Through the Economic Cycle

Historically, three key drivers contribute to fallen angel returns. First, there is the technical effect described above from buying discounted bonds, driven by the distinction between the investment grade and high yield bond markets.

Another factor has been differentiated sector exposures. Broad economic events tend to impact entire sectors together. “Hot” sectors are generally characterized by tight spreads and few downgrades, so the fallen angel universe is typically underweight that sector versus the broad high yield market. Sectors where fundamentals have bottomed out tend to see a large number of downgrades, and therefore are likely to be overweight in the fallen angel universe. In other words, outperformance potential can come from participation in the recovery of beaten down sectors as well as the avoidance of high-flying areas of the economy where leverage may be increasing.

Lastly, the higher quality tilt of fallen angels³ relative to broad high yield has provided outperformance historically by providing downside protection during selloffs, and also through their higher exposure to “rising stars,” which are high yield bonds that are upgraded to investment grade.

Different stages of a market cycle are characterized by changes in interest rates, spreads, downgrades and volatility. The three return drivers mentioned above play different, and in many cases diversifying, roles in each environment. For example, when there is a high level of downgrades, there may also be elevated spread volatility, so both the technical effect of buying discounted bonds and the higher quality may provide a buffer to returns. However, sector exposures may detract if there is an overweight to struggling sectors. In a recovery, the fallen angel technical effect may wane as downgrades become more idiosyncratic, while a recovery in certain sectors may be a tailwind. This is illustrated below in a highly stylized representation of the economic cycle, which also lists the key drivers of fallen angel returns in order of expected magnitude. Of course, every cycle is different, so this is meant to serve only as an illustration. Knowing exactly where we are in the cycle is impossible until after the fact. Nevertheless we believe this can be illustrative of these effects and also provide support in explaining the consistency of outperformance of fallen angels through various market cycles.

The Technical Effect of Fallen Angel Bonds Through Credit Cycles

Source: VanEck

Outperformance of Fallen Angel Bonds in Different Market Environments

In 2020, performance was driven primarily by increased downgrade volume and corresponding deep discounts. 2019 was a very different environment, but one where fallen angel high yield bonds still provided strong absolute (+17.3%) and relative (+2.9% versus broad high yield) as performance.⁴ Unlike 2020, 2019 downgrade volume was the lowest on record since the fallen angel index was launched. Instead, 2019 returns were driven by security selection and sector allocation – a reflection of the value in the strategy’s contrarian approach and ability to benefit from recoveries in previously beaten down names.

Also notable are the factors that have not driven historical returns. Changes in interest rates, for example, have not historically been a primary driver of long-term fallen angel outperformance. All else equal, the higher duration of fallen angels may benefit the strategy in periods of declining rates but will generally detract in rising rate environments. Historically, however, fallen angels have historically outperformed in rising rate environments, including seven of the last nine years in which interest rates rose significantly.⁵ In those years, the key drivers of fallen angel returns more than offset the impact of rising interest rates.

In addition, absolute spread levels are not necessarily an impediment to attractive absolute or relative returns. In the chart below, we highlight five periods in which high yield spreads were below their long-term average, and show the cumulative performance of fallen angels index versus the broad high yield bond market index in each of those periods. Returns of fallen angels index were not only significant in absolute terms, but also outperformed broad high yield index by an average of 400 basis points. The one exception was 2003 through 2007, in which fallen angels provided performance that was in line with the broad market, with a 30% cumulative return.

Fallen Angel Bonds Show Strong Performance Despite Below-Average Spreads

Source: ICE. Past performance is not indicative of future results. Fallen Angel U.S. High Yield by the ICE US Fallen Angel High Yield 10% Constrained Index (H0CF) and Broad U.S. High Yield by ICE BofA High Yield Index (H0A0). Fallen Angel U.S. High Yield index data on and prior to February 28, 2020 reflects that of the ICE BofA US Fallen Angel High Yield Index (H0FA). From February 28, 2020 forward, the Fallen Angel U.S. High Yield index data reflects that of the Fund's underlying index, the ICE US Fallen Angel High Yield 10% Constrained Index (H0CF). Fallen Angel U.S. High Yield index data history which includes periods prior to February 28, 2020 links H0FA and H0CF and is not intended for third party use.

Could Quality and Sector Exposures Drive 2021 Returns?

For 2021, we frame our expectations in terms of the following three key performance drivers:

Higher quality: Given today’s low absolute spread levels, the market may be susceptible to bouts of volatility and drawdowns, and fallen angels may provide a cushion in such periods, compared to lower rated high yield bonds. Higher economic growth and continued low rates, however, will be generally credit positive, in our opinion. In this more favorable credit environment, we think the bigger story could be the potential for more rising stars. As we wrote about recently, rising stars have historically gained over 6% in price in the 12 months prior to upgrade, compared to an average return of -1% on the broad high yield index over the same corresponding periods. In addition, the fallen angel index has historically experienced a greater level of rising stars compared to the broad high yield market. There were only two rising star issuers in 2020, but the outlook has brightened for 2021, with several rising stars in the broad high yield market compared to no fallen angels in January.

Notably, Cenovus Energy, an integrated energy issuer, left the fallen angel index at the end of January with a 2.3% weight following a credit rating upgrade by Moody’s Investors Service. Since entering the index in April 2020 at an average price of $74, the bonds rallied nearly 50% in price prior to exit. With 95% exposure to BB bonds, and 56% BB+, fallen angels are well positioned to benefit from a more positive credit environment.

Sector differentiation: The fallen angels index ended 2020 with the highest overweights versus the broad high yield market index to the energy, consumer goods and automotive sectors. With higher expected growth as vaccine rollout continues and additional policy support likely, these economically sensitive sectors may be positioned to outperform the broader market. In particular, the energy sector may stand to benefit from both increased demand and tighter supply. Spreads in some sectors, including autos and banking, remain higher than they were prior to the widening that began in February 2020. Within each sector, higher exposures to issuers with greater upside potential may also drive returns.

Fallen angel technical effect: As mentioned, a repeat of 2020 is unlikely. However, the BBB- segment of the investment grade market—one notch away from high yield—remains extremely sizeable at $1.1 trillion. Nearly $250 billion of this is one ratings action away from having an “average” rating to fall to high yield, which would result in the bonds coming out of investment grade benchmarks and being added to high yield and fallen angel benchmarks. Even if only a portion of this segment is ultimately downgraded to high yield, 2021 could still be a very meaningful year for fallen angel downgrades from a historical perspective, 2020 notwithstanding. Rather than the systemic downgrades of last year however, downgrades this year are likely to be more idiosyncratic, in our opinion.

One year ago, although we were expecting an increase in fallen angel high yield bonds, we had no idea that a pandemic-driven selloff was right around the corner and could not have predicted the degree of ratings actions that actually happened. Given the inherent uncertainty investors face, the historical consistency of outperformance may provide confidence to high yield investors of the value that fallen angels can provide through various economic cycles and in changing market environments.