Exchange-traded fund provider Invesco PowerShares has unveiled its first fixed income product in the European market with the launch of the PowerShares US High Yield Fallen Angels UCITS ETF (LSE: HYFA). The physically replicating ETF provides exposure to USD-denominated ‘Fallen Angel’ bonds of issuers domiciled in North America. Fallen angels are bonds that were originally issued with investment grade status but have since been downgraded to junk.
Bryon Lake, Head of Invesco PowerShares – EMEA.
The ETF, which has been listed on the London Stock Exchange, is based on the premise that the overly negative sentiment surrounding a downgrade into junk status causes fallen angels to be regularly oversold as investors, often forced by their investment mandate, sell en masse prior to and at downgrade, leading to a price anomaly..
Bryon Lake, Head of Invesco PowerShares EMEA, commented: “With the fallen angel phenomenon there are two things going on that are pushing the bond price down. First leading up to the downgrade you tend to see prices begin to drop as investors position themselves for the downgrade. Secondly, after the downgrade there are large asset owners, usually institutional in nature, that are forced to sell what were investment grade bonds but are now high yield due to their strict mandated rules. This forced selling creates a phenomenon where the bond can become oversold, which creates an opportunity to buy the bonds at their existing market value. This overselling – more often than not – is followed by a rebound in the bonds prices, potentially creating a unique opportunity and in a number of instances the bond even returns to investment grade.”
The fund is linked to the innovative smart beta-esque Citi Time-Weighted US Fallen Angel Bond Select Index, which is part of an index series introduced by financial giant Citigroup in November 2015. The index is time-weighted, allocating higher weights to those bonds that have been downgraded most recently in an attempt to maximise the return from any ‘V-shaped’ bounce the downgraded bonds may exhibit.
Unlike traditional bond indices, where constituent weights are based on the market value of outstanding debt issuance, constituent weights are determined based on the time from inclusion in the index. Any bond entering the index is given a predefined time score and, starting from the 13th month upon entering the index, that score is gradually reduced. On each monthly rebalance, the time scores for all bonds in the index are normalized to weights that sum up to 100%.
According to Lake:“By using a time-weighted methodology, the index emphasises the bonds that were most recently downgraded, which is logical in the context of a fallen angel strategy vs say market cap weighting, and also could enhance the return of the ETF by more acutely capturing the ‘fallen angel’ phenomenon.”
Issuers’ weights are capped at 5% and individual bonds’ time-based weights are capped at five times their respective market value based weights to help manage concentration risk. Bonds have a minimum rating of C by S&P, and Ca by Moody’s, and a maximum of BB+ and Ba1 respectively.
Arom Pathammavong, Global Head of Citi Fixed Income Indices, said: “For the Citi Time-Weighted US Fallen Angel Bond Select Index, we examined the price movements of fallen angel bonds which showed that prices of these bonds tend to recover from the dip of the downgrade over a 30-60 month period. The index will hold these fallen angel bonds for up to 60 months while applying an innovative time-based weighting methodology that aims to capture the price rebound effect of these bonds.”
The performance of the index appears to have been strong. According to backtest data from Citi, from an index base date of 31 December, 2001 to 30 October, 2015, the index delivered an annualised return of 11.64% with standard deviation of 11.95% compared to an annualised return of 7.94% with standard deviation of 10.07% for the Citi US High-Yield Market Index. Of course, backtested performance has inherent limitations and typically ignores factors such as trade timing and costs, and security liquidity. Moreover, the economic and market regime in the future may differ significantly from that of the past, but it nonetheless provides an illustration of the potential of the time-based weighted approach to fallen angel bonds
Risk and Return for the Citi Time-Weighted US Fallen Angel Bond Index compared to the Citi US High-Yield Market Index, 31 December, 2001 – 30 October, 2015. (Citi Fixed Income Indices. Backtest data for illustrative purposes,)
As of 29 July 2016, the index was composed of bonds primarily with ratings of BB+ (25.3%), BB (25.3%), BB- (23.1%) and to a lesser extent those rated B+ (10.8%). The largest sector allocations were to energy (35.0%), industrial manufacturing (24.2%) and industrial services (12.9%). The index’s weighted average yield-to-maturity was 6.69% and its effective duration was 5.51 years.
Issuers with significant weights currently include Canadian metals and mining company Teck Resources (5.1%), American fast food company Yum! Brands (5.1%), Oklahoma-based energy group Williams Companies (4.9%), US-headquartered copper producer Freeport McMoRan (4.5%) and Switzerland-headquartered offshore drilling contractor Transocean (4.2%).
The ETF may appeal to investors who are looking for exposure to the North American high-yield bond market but who are dissatisfied with a conventional market cap-weighted approach and looking for a potential pick-up on mainstream junk bonds. Its time-weighted approach also means the fund tends to invest more heavily in bonds near the higher quality end of the junk bond spectrum, allocating to bonds which have only just been downgraded rather than those that have slipped further down the quality scale. This potentially positions the fund to be better able to avoid bonds that are perilously close to default.
The ETF has a total expense ratio (TER) of 0.45%. It is due to be rolled out on Borsa Italiana, Deutsche Borse, Euronext Paris and SIX Swiss Exchange later in the month.
The fallen angel genre is fairly under-explored from the perspective of ETFs, with very few products specifically targeting the segment currently available. Those that do exist include funds from iShares (both European and US-listed products) and Van Eck (US listed).
In Europe, the iShares Fallen Angels High Yield Corporate Bond UCITS ETF (LSE: WING) is the only other fallen angel bond ETF. It tracks the Barclays Global Corporate ex EM Fallen Angels 3% Issuer Capped Index, an index measuring the performance of fallen angels globally, excluding those from emerging markets. The index has exposure to over 450 holdings with a cap on a single issuer of 3% of the total market value to ensure diversification. Emerging market issuers and bonds rated below B- are excluded as part of its screening process. Launched in June 2016, the ETF has gathered $140m in assets under management (AUM) and has a TER of 0.50%. As well as the LSE, it is listed on SIX Swiss Exchange and Deutsche Boerse. It is up 3.7% between its inception and 1 September 2016.
In the US, iShares offers the iShares Fallen Angels USD Bond ETF (FALN). The fund tracks the Barclays US High Yield Fallen Angel 3% Capped Index, which is designed to reflect the performance of US dollar-denominated fallen angels. Bonds are market value weighted with a 3% cap on each issuer. It is has an expense ratio of 0.35% but is very small, with just $10.5m in assets. Much larger is the VanEck Vectors Fallen Angel High Yield Bond ETF (NYSE Arca: ANGL), which tracks the BofA Merrill Lynch US Fallen Angel High Yield Index. The fund has AUM of $324m and comes with a TER of 0.35%. It is up 22.2% year-to-date.