Systematic Insights: don’t forget fallen angels amid rate cuts | Insight Investment

We recently discussed how fallen angels may look compelling to investors given an uptrend in downgrades. But it may also be a particularly compelling time in the cycle to consider them.

As an economic slowdown looms, fallen angels may offer a level of comfort given three-quarters of the market is BB (versus ~50% for the broad high yield market). Further, rate cuts are potentially around the corner, and likely to kick off a renewed wave of monetary easing over the coming years (Figure 1). We believe fallen angels, a high-quality component of high yield, may be particularly well placed to benefit.

Figure 1: The rate cutting cycle could finally be about to resume¹

Naturally, from a price perspective, bonds tend to benefit from rate cuts, particularly those assets with more interest rate risk and less credit spread exposure, such as Treasuries or investment grade corporates. While high yield corporates typically offer a yield advantage, they generally have less interest rate risk than investment grade bonds.

However, fallen angels may be able to offer the best of both worlds. As former investment grade companies, they tend to have longer duration exposure than high yield bonds (at ~5 years versus ~3 years). They also offer similar credit spreads to the broader high yield market. Since the US fallen angel index² launched in 2005, there have been four periods in which Treasury yields were generally falling and five in which they were rising (Figure 2). 

Figure 2: Tracking the US fallen angel index across monetary policy cycles³

During the “falling rate” periods, US fallen angels have indeed reliably outperformed US high yield bonds (Figure 3). More surprisingly, they have even outperformed high yield through rising rate periods on average (albeit more modestly and less reliably cycle by cycle).

Figure 3: Fallen angels may be a compelling “all weather” fixed income asset class⁴

But interest rate risk may not be the only factor, during falling rate periods, $522bn bonds were downgraded to fallen angel status, versus only $368bn during the rising rate periods. This likely reflects the fact that rates tend to fall during periods of economic stress.

As we previously discussed, downgrade activity can be a key tailwind for fallen angels, as they result in forced selling from passive investment grade accounts, potentially allowing fallen angel investors to purchase them at oversold levels.

Looking ahead, we believe that falling interest rates, combined with a growing number of issuers being downgraded below investment grade, could serve as dual tailwinds for fallen angels strategies. Even if rates decline more gradually than expected, investors may still benefit from the additional spread this asset class offers over higher-rated credit.