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    Fallen angels: the essential high yield overweight?

    Fallen angels: the essential high yield overweight?

    January 26, 2022 Fixed income

    We believe that high yield investors can benefit from including a dedicated fallen angels strategy as a permanent "overweight" within their allocation.

    Within the high yield market Fallen Angels have:

    • Delivered highest returns, despite the highest credit quality in high yield
    • Outperformed other high yield categories during rising rate periods
    • Outperformed other high yield market categories during the pandemic

    Fallen Angels are higher quality high yield bonds, and have delivered higher returns

    Currently, 92% of the Fallen Angels index has a Ba rating (the highest in the high yield market), making it the highest quality high yield category in terms of credit rating when compared to the broad market and the liquid segment (Table 1).

    Table 1: Fallen Angels tend to have higher credit quality than broad high yield1

    As of October 2021 Broad Liquid Fallen Angels
    Ba exposure 54% 42% 92%
    B exposure 35% 46% 6%
    Caa and lower 12% 12% 2%


    Despite this, Fallen Angels have delivered relatively high returns since 2004, when granular data become available. The broader market has performed in a lower-octane fashion, while the liquid market has performed less well on a risk-adjusted basis (Figure 1).

    Figure 1: Fallen angels have delivered higher returns than the other categories2


    On a rolling 3-year and 5-year basis to the end of October 2021, Fallen Angels have outperformed the other categories 90% and 100% of the time respectively.

    Furthermore, Fallen Angels saw the lowest maximum drawdown of the three during the period (Figure 2).

    Figure 2: Fallen Angels, despite high volatility, has seen the lowest maximum drawdown3


    Fallen Angels have even outperformed the other high yield indices when rates have risen, despite their greater rate risk

    Fallen angels tend to be longer dated than other high yield bonds, and thus have higher interest rate risk. Despite this, they have largely outperformed the other categories during the seven periods since 2004 that rates have risen (Figure 3).

    Figure 3: Fallen Angels have generally outperformed other high yield bonds when rates have risen4


    This is partly because rates tend to rise when the economy is improving, and thus when credit spreads are

    So, while Fallen Angels have historically seen negative contribution from interest rate risk when yields have risen, they have seen a greater positive return contribution from credit spreads, more so than the other areas (Figure 4).

    Figure 4: Fallen Angels have generally seen the highest total returns through rising rates5


    Fallen Angels also offer potential for capital gains during economic upswings

    Fallen Angels have delivered higher returns than the other high yield markets despite the fact they have lower yields and credit spreads (a consequence of their higher credit ratings).

    This is largely due to inefficient market dynamics. Fallen Angels suffer ‘forced selling’ from passive investment grade accounts when downgraded to high yield, frequently causing disproportionate spread widening during the month of the downgrade, which often reverts once trading activity normalizes. Similar ‘forced buying’ occurs for rising stars, aggressively tightening spreads (see Catch a Rising Star: Fallen Angels may hold the key for more). As such, despite lower credit spreads, Fallen Angels’ total returns have historically seen the highest credit spread performance (Table 2).

    Table 2: Fallen Angels have historically seen greater contribution from credit spreads since October 20046

      Broad HY Corp Liquid HY Corp Fallen Angels Corp
      Total return Spread return Rate Return Total return Spread return Rate Return Total return Spread return Rate Return
    Jun 2005 - June 2006 4.82% 5.96% -1.14% 3.92% 5.48% -1.56% 2.25% 4.27% -2.02%
    FY 2009 58.21% 59.83% -1.62% 63.43% 65.62% -2.13% 73.08% 75.52% -2.44%
    Sep 2020 - Mar 2011 10.45% 12.53% -1.90% 11.50% 13.82% -2.33% 10.25% 13.24% -3.18%
    Aug 2012 - Dec 2013 13.86% 16.00% -2.15% 13.20% 15.65% -2.45% 17.45% 21.61% -4.15%
    Aug 2016 - Dec 2016 4.59% 7.34% -2.75% 4.58% 7.77% -0.08% 5.48% 10.18% -4.70%
    Sep 2017 - Mar 2021 2.31% 3.81% -1.51% 1.10% 2.98% 2.08% 2.40% 5.48% -3.07%
    Aug 2020 - Mar 2021 7.27% 9.64% -2.37% 6.82% 8.99% 0.08% 9.93% 15.57% -5.64%
    Simple Average 14.50% 16.24% -1.92% 14.94% 17.19% 2.22% 17.26% 20.86% -3.60%


    Fallen Angels have outperformed when downgrades are high

    Historically, the Fallen Angels index has outperformed the broad market during periods of high downgrade activity. This potentially provides a free ‘call option’ versus the broad market for when market conditions become challenging (Figure 5).

    Figure 5: Fallen Angels have delivered solid performance through difficult markets5


    We believe that high yield credit offers value as a strategic allocation as we transition from the early cycle rebound to the mid cycle (see: Credit: the asset class to watch for the mid cycle?).

    We also believe that a dedicated Fallen Angels allocation can enhance a high yield investment strategy, especially for investors able to access innovative liquid sources in fixed income.

    Fallen Angels have delivered, in our view, compelling historical risk-adjusted returns and offer potential upside through difficult market conditions, spells of strong economic growth and periods of rising rates.

    In our view, investors may find Fallen Angels valuable as a core allocation within high yield, a higher-octane high yield strategy (but with defensive characteristics) that complements a private debt allocation or a compelling allocation within a multi-manager framework.

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