Spreads in Control

In March, fallen angels (as represented by the ICE US Fallen Angel High Yield 10% Constrained Index, “H0CF”) outperformed the broad high yield market (as represented by the ICE BofA US High Yield Index, “H0A0”) by 0.24% (1.43% vs to 1.19%), and year-to-date, they are leading by 0.10%, with returns of 1.61% vs 1.51% for the broad high yield market.The majority of this outperformance can be attributed to tighter credit spreads, as fallen angel spreads tightened by 38bps compared to 24bps for the broad high yield. The impact offset the rise in bond yields. Hotter than expected inflation and jobs numbers so far this year have driven a re-pricing of market expectations for rate cuts to better align with U.S. Federal Reserve (Fed) guidance and some are now wondering if there could be no rate cuts at all this year. Longer term bond yields have moved upwards and as a result, yields on fallen angels (currently approximately 7%) remain significantly higher than historical averages despite the tightening of spreads over the past six months.

Spreads Drive Outperformance

The price return of fallen angels has historically served as a significant distinguishing factor compared to the broad high yield market from a total return perspective. Bonds that experience downgrades to high yield often undergo a recovery in the subsequent months following the rating adjustments. Typically, a higher volume of downgrades correlates with higher returns, as evidenced during events like the COVID-19 pandemic or the oil crisis of 2016. However, over the past few years, the strong credit environment has led to a dearth of new fallen angels, and the higher duration of fallen angels has driven a lag in price returns versus the broad HY market over the 1-year and 3-year periods. This has been offset, to a degree, by positive price performance of a significant number of “rising stars” over the period. The higher quality of fallen angels has also been a return detractor relative to the broad market, given the strong risk-on environment we’ve seen recently and the generally lower yields of the segment.

More recently, fallen angels have outperformed broad HY, following the pause of the Fed's hiking campaign in the summer of 2023 and the rise in bond yields over the past 3 years subsiding. Although bond yields remain elevated and we expect to continue to see bouts of rate volatility (similar to what we’ve seen recently), we generally expect long term yields to be range bound over the next year or so. Rate cuts down the road provide the potential for a duration tailwind, although we are generally expecting yield curve normalization rather than a significant decline in long-term bond yields, at least based on the current macro environment.

As the Fed contemplates rate cuts sometime this year, high yield investors should not focus solely on every data point the Fed considers but rather acknowledge that rate cuts are likely coming, and what the impact on the asset class may be. Historically, once the Fed initiates its easing cycle, BB-rated bonds have demonstrated outperformance (as discussed in our 2024 outlook) within high yield.

Cumulative Price, Income and Total Return

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 dipped 17bps to 6.92% in March, but are overall flat so far this year while spreads keep trending downwards, finishing Q1 at 247bps. We haven’t been at these levels since January 2022 when the average spread reached 204bps. Given that inflation and interest rates are likely to remain elevated for longer, with the 10Y rising to 4.20% from 3.88% at the end of last year, we believe investors may capitalize on the advantages of the relatively high yields and attractive credit fundaments within the higher quality segments in high yield. Regarding defaults, the broad high yield market witnessed two issuers default in March: Enviva and Curo Group ($1,750 million par outstanding), adding to Cano Health and Audacy Capital Corp for a total of $3,044m vs $0 for fallen angels.

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: There were no new fallen angels in March, and a total of two in the first quarter of 2024. We continue to monitor issuers that may be impacted by commercial real estate exposure. S&P downgraded five regional bank (First Commonwealth Financial, M&T Bank, Synovus, Trustmark Corp and Valley National Bancorp) outlooks due to their real estate exposure and the continuing challenges within the space, especially in the office property market as office vacancy rates hit an all-time high of 19.6% at the end of 2023, according to Moody’s Analytics. Outside of real estate, Moody’s placed Boeing’s Baa2 rating on review for downgrade as they believe Boeing will be unable to deliver enough planes to maintain free cash flow, but the company remains multiple notches away from high yield. Closer to fallen angel status is Paramount Global, as both S&P and Fitch downgraded it (Fitch to BBB- from BBB;S&P to BB+ from BBB-) citing continued cord cutting and elevated costs of building their streaming services.

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: Enlink Midstream exited the index in March, after joining in July 2018 at $90.71, as S&P upgraded it to BBB+ from BB+ due to a significant reduction of its leverage over the past several years. During its time in the fallen angel index, Enlink provided a price return of -1.98% but a total return of approximately +45% vs the energy sector at approximately +11%.

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 within fallen angels is now 18% (an increase of more than 3% YTD) while Energy sector exposure is now close to 11% (a decrease of more than 3%), after Enlink exited the index. Leisure exposure was cut in half during the quarter after LVS exited in February. In terms of spreads, all sectors except Banking, Basic Industry and Telecom saw their spreads tighten YTD, with the Real Estate sector now 148bps tighter than at the beginning of the year but still above 500bps. In terms of attribution relative to broad high yield, the outperformance so far this year was notably influenced by fallen angels being overweight Retail (almost 3x) and the lack of Media exposure. Fallen angels underweight to Basic Industry and Services detracted the most during Q1.

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 and in the general broad high yield market, CCC and lower rated issuers continue to outperform their higher rated peers as they’ve had better than expected earnings. For context, CCC and lower rated bonds (as the ICE BofA CCC & Lower US HY Index) have outperformed the broad HY market 12 times in the last 16 months and YTD, CCC and lower rated bonds are up 3.22% vs 1.51% for the broad market.

Source: ICE Data Services, VanEck. 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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