ETFs providing exposure to fallen angel bonds may offer investors a significant value opportunity due to price dislocations caused by the onslaught of downgrades in the wake of Covid-19.
The number of fallen angels has increased at the fastest rate since the financial crisis.
According to data from S&P Global, the number of fallen angels – bonds that were rated investment grade upon issuance but have since fallen to high-yield status – rose by 24 globally year-to-date (30 April), the largest increase since the financial crisis.
Cyclical sectors such as financials, energy, and consumer discretionary have recorded the highest number of downgrades, reflecting the severe economic impact of global lockdown orders as well as the sharp drop in oil prices.
Additionally, the number of potential fallen angels – investment-grade bonds on the cusp of junk – has climbed from 96 to a record 111, highlighting further downgrades may be on the horizon.
Yet, while these firms have borne the brunt of the market sell-off earlier in the year, many analysts have highlighted the potential for a rebound.
The fallen angels’ investment thesis 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.
There is considerable research to back up this theory. A study by financial research firm Morningstar found that the forced selling of fallen angel bonds leads to an average price decline of nearly 9.0% in the five weeks following the downgrade. However, prices tend to recover their fundamental value within 30 weeks on average.
Due to the high number of current downgrades and credit pressure continuing to build – S&P Global notes that a quarter of potential fallen angels are on negative credit watch – value investors have started to take notice.
The $1.9 billion VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL US), the largest ETF to target fallen angels, gathered $340 million in net new assets during April and May. The fund tracks the BofA ML US Fallen Angel High Yield, focusing on US dollar-denominated fallen angels from issuers worldwide.
In Europe, investors can access the fallen angels theme in UCITS format through the VanEck Vectors Global Fallen Angel High Yield Bond UCITS ETF (GFA LN) and the iShares Fallen Angels High Yield Corp Bond UCITS ETF (WING LN), both of which invest in fallen angel bonds issued globally.
The other option for European ETF investors is the Invesco US High Yield Fallen Angels UCITS ETF (HYFA LN) which focuses on US dollar-denominated issues from North American firms.
All three ETFs experienced positive net inflows during May.
While the VanEck and iShares ETFs track market-value-weighted fallen angel indices, the Invesco ETF offers a twist on the theme. The fund tracks the Citi Time-Weighted US Fallen Angel Bond Select Index which allocates a higher weight to bonds downgraded most recently, a strategy that may help maximize the return from any ‘V-shaped’ bounce the downgraded bonds may exhibit.
Investors should note that fallen angel bonds typically exhibit higher interest-rate risk than the broader high-yield market; however, interest rates are expected to remain low while central banks continue to combat the Covid-19 fallout.
Fallen angel bonds also generally offer a higher credit quality with the vast majority of fallen angels never slipping below the BB credit threshold.
Despite these significant differences, as well as the spike in fallen angel activity, fallen angel ETFs have so far closely tracked the return on the high-yield market. The VanEck Vectors Fallen Angel High Yield Bond ETF is down -4.3% year-to-date (as of close 1 June) compared to -4.8% for the iShares iBoxx $ High Yield Corporate Bond ETF (HYG US).
Fallen angels high yield performance
There are several explanations for the present harmony. Firstly, as noted previously, any ‘bounce’ attributed to fallen angels often takes over six months to play out. Secondly, fallen angel ETFs follow rules-based reconstitutions at set intervals throughout the year – as such, many have only recently included the current downgrades. Lastly, accommodative policies from the Federal Reserve, including a pledge to buy investment-grade and high-yield bond ETFs, have added broad support to credit markets in the short-term.
Whether the fallen angels strategy will end up outperforming the high-yield market in 2020 may largely depend on the extent to which Covid-19 will end up being just a major cyclical disruption or will lead to lasting structural changes.
Historically, cyclical downturns have led to increased fallen angel volume and the subsequent outperformance of fallen angel ETFs as the strategy goes overweight sectors where fundamentals have bottomed out. Structural changes, however, are more likely to turn fallen angels into ‘fallen knives’ as companies struggle to recover in the new environment.
However, as the world emerges from lockdown and economies stir to life, equity investors appear to be betting on a swift cyclical rebound. Industrial, financial, energy, and consumer discretionary ETFs all outperformed the broader stock market during the final two weeks in May, a potentially bullish signal for recent fallen angels.