Systematic Insights: Don’t Sleep on Fallen Angels | Insight Investment

Fallen angels have consistently outperformed comparable credit markets over most time periods. With the potential for rising downgrades, it could be time to consider a systematic approach to the asset class.

Fallen angels have performed consistently well against other credit markets

Fallen angels (bonds downgraded from investment grade to high yield) have quietly outperformed other comparable fixed income markets over most near and longer-term time periods (Figure 1). Their only notable weak spot versus US high yield was over five years, a result of 2022’s rising rate environment.

Figure 1: Fallen angel returns have been strong over most time periods¹

The main driver of this performance has been credit spread (or “excess”) returns (Figure 2). This may be surprising, as fallen angels are generally higher quality than high yield (~75% of fallen angel market is BB rated vs ~55% for high yield), and therefore generally have narrower credit spreads than other high yield bonds¹.

This performance is partially explained by fallen angels having a higher “credit spread duration” than high yield bonds (which means their bond prices have a higher sensitivity to changes in credit spreads). As former investment grade companies, their bonds tend to have longer maturities than other high yield bonds, so in essence, they have historically enjoyed an amplified impact from credit spread tightening relative to high yield.

Figure 2: Credit spreads, not interest rates, have driven strong fallen angel performance versus high yield¹

Can a wave of downgrades improve near-term fallen angel returns further?

Historically, waves of fallen angel downgrades have been an additional driver of fallen angel returns.

When bonds transition from investment grade to high yield indices, many passive (and some active) investment grade accounts become simultaneous “forced sellers”. This may lead to overselling, creating potentially compelling entry points for other investors.

We recently noted that sector downgrade waves historically coincided with higher fallen angel returns, and flagged business development companies as a sector to watch for downgrade candidates (Figure 3).

Figure 3: Waves of sector downgrades have historically been good news for fallen angel investors²

We see signs that downgrades may also pick up across other sectors. Fallen angel downgrades have been low since the pandemic, but $30bn has entered fallen angel indices year-to-date, already making it the highest level since 2020 (Figure 4).

Figure 4: Fallen angel downgrades have been muted, but is an uptick coming?³ 

Economic conditions may also indicate potential catalysts for downgrades

Consumers, particularly lower-income cohorts, are increasingly dipping into savings to support consumption, leaving the personal savings rate at its lowest level since 2022⁴. We believe this may impact certain credits.

Trends are also moving toward higher M&A activity. Goldman Sachs forecast M&A volumes of $3.8trn in 2026⁵, driven by factors like deregulation and AI-related disruption and consolidation.

We are watching fundamentals, rating agency outlooks and pricing within BBB names in particular. We expect to see downgrades return to more historically normal levels of $40bn to $50bn per year.

Getting ahead of future downgrade waves may be an optimal strategy

In our view, total returns over recent years offer potential evidence that the fallen angel market may offer value even absent a wave of downgrades. We believe the optimal time to invest may be now, before the next wave of downgrades arrives, even if the timing of downgrades is uncertain.