Catch a rising star: fallen angels may hold the key | Insight Investment

'Rising stars' present potential opportunity as the economy recovers. Investing in a portfolio of fallen angels may be an efficient way to capture future rising stars.

Executive Summary

• The economic recovery could be a breeding ground for ‘rising stars’ – the term for companies that get upgraded from high yield (HY) to investment grade (IG).
• Historically, rising stars are almost twice as likely to come from the fallen angel market than the broader HY market.
• A dedicated fallen angels strategy may offer the most efficient path for capturing rising stars, while offering historically equity-like returns for bond-like volatility.

Rising stars set for launch?

A recovering economy is potentially a breeding ground for rising stars

Companies are more likely to upgraded during periods of economic growth and recovery, as rising revenues feed into stronger balance sheet metrics (Figure 1).

Figure 1: A rising tide potentially launches rising stars¹

As the US economy recovers, it is progressing into the ‘mid cycle’ phase of the expansion, driven by consumer spending and public and private investment. We anticipate ~$100bn of rising stars to emerge from the high yield market now until the end of 2022, up from $20bn in H1 2021 and $20bn in 2020.

The 'ratings cycle' may also encourage upgrades

Many fallen angels are incentivized to return to IG status (Figure 2).

Figure 2: The ‘ratings cycle’ describes why many fallen angels are more likely to become rising stars²

Many fallen angels were downgraded ‘voluntarily’ by engaging in equity-friendly behavior (such as share buybacks or M&A), resulting in higher leverage. Once downgraded, equity-friendly activity is more aligned with bondholders – such as growing into more creditworthy entities or voluntarily reducing leverage to enjoy significantly lower interest costs. For example, consider Kraft Heinz, the food giant which was created in an equity-friendly mega-merger in 2015. The deal left the resulting entity highly leveraged with $30bn in outstanding debt. Ultimately, it was downgraded from investment grade to fallen angel status in 2020. Since then, the company has notably pivoted its strategy, recently announcing bond buybacks and selling Planters, Corn Nuts and other businesses for $3.4bn to reduce debt, likely in effort to reclaim its investment grade status³.

Three stages of rising star outperformance

A rising star’s outperformance tends to occur in multiple stages as ratings agencies can lag market pricing.

Stage 1: Journey begins

Up to three years or more before an upgrade, a future rising star begins deleveraging. Bottom-up investors take note, resulting in narrower spreads. Eventually, over this time period, the issuer becomes a clear candidate for an upgrade and spreads outperform versus peers.

Stage 2: Upgrade announced

The rating agencies announce the upgrade, the market reacts positively and spreads tighten in anticipation of future buying from a larger IG asset base.

Stage 3: ‘Forced’ buying

Once upgraded, at month end, passive funds and ETFs will rebalance their portfolios and become forced buyers to minimize tracking error. In anticipation of this buying activity, volumes pick up in these names and spreads tighten further.

Figure 3: The stages of rising star performance⁴

Challenges with traditional approaches

There are three key challenges to traditional concentrated approaches:

1. Concentration risks: The pool of potential rising stars has historically been ~5% of the broader HY market on average. Traditional approaches to specifically targeting just this opportunity set means high concentration risks, and thus a high impact from volatility

2. Timing challenges: Pin-pointing early-stage rising stars can be tricky, and the penalty for getting it wrong can be severe. Rating agencies each have specific methodologies and two agencies typically need to upgrade a bond before passive accounts start buying them.

3. High transaction costs: The HY market offers relatively low two-way liquidity in single bonds, particularly within smaller issuers (which could be early-stage rising star candidates). High transaction costs would potentially limit active trading.

'Fallen angels' could hold the key to capturing rising stars

In our view, a diversified ‘fallen angels’ portfolio could be a compelling way to catch rising stars early and reliably.

Historically, rising stars are almost twice as likely to come from the fallen angel market than the broader HY market (Figure 4).

Figure 4: Rising stars make up a higher proportion of the fallen angels market than HY⁵

Over 250 US bonds became fallen angels during 2020, increasing the pool of upgrade candidates (Figure 5).

Figure 5: A spike in fallen angels in 2020 has increased the pool of rising star candidates⁶

Barclays estimates that 30% of 2020’s fallen angels will rebound to rising star status⁷ and JP Morgan expects $297bn in total rising star upgrades⁸. In 2021 so far, names such as Cenovus Energy, Nordstrom, MTNA and ArcelorMittal have even already returned to IG-status, having been 2020 fallen angels⁹.

Fallen angels have also been upgraded at an accelerating pace in recent years, indicating that now is potentially an ideal time to consider a fallen angels strategy.

Figure 6: Former fallen angels have been returning to IG at an improving pace¹⁰

Fallen angel strategies may also offer additional tailwinds

Fallen angels have historically delivered returns in line with equity markets despite volatility in line with bond markets (Figure 7).

Figure 7: Fallen angels have delivered equity-like returns for bond-like volatility¹¹

Fallen angels are often large multi-nationals with large capital structures, whereas traditional high yield companies tend to be smaller businesses with less access to capital markets. For example, three of the larger fallen angels in the index are household names such as Ford, Delta Airlines and Vodafone¹². Fallen angels were once investment grade rated and had access to capital at lower funding rates. Upon downgrade, many of these fallen angel corporations are incentivized to repair their fundamentals to get access to that cheaper capital again. As such, intuitively and empirically, fallen angels are potentially stronger rising star candidates on average.

Playing rising stars: fallen angels could be the key

In our view, casting the net wide in a diversified, fully dedicated fallen angels strategy may be a compelling solution for a wide range of investors looking to access rising stars.

The asset class may help fit multiple needs for pension plans, such as compelling yield and income streams to cover future pension obligations and well as the growth potential to help close funding deficits and participate in the economic recovery.

Insurance investors may also benefit from the income streams of the fallen angels market, particularly if they can receive favorable capital treatment on BB rated corporate bonds given fallen angels are mainly BB rated.

We believe that investors need to consider managers with the ability to overcome the liquidity challenges of reliably delivering the performance of the fallen angels market, such as managers able to unlock the ‘hidden liquidity’ within the fixed income ETF infrastructure.