European fixed income ETF specialist Tabula Investment Management has launched a new innovative fund providing exposure to so-called ‘fallen angel’ bonds while adhering to the climate objectives of the Paris Agreement.
THFA is the first ETF globally to deliver climate-considered exposure to fallen angel bonds.
The Tabula Global High Yield Fallen Angels Paris-aligned Climate UCITS ETF (THFA LN) has been listed on London Stock Exchange in US dollars, coming to market with $50 million in initial assets.
THFA is the first Paris-aligned ETF globally to specifically target the market for fallen angels – bonds that were originally issued with investment grade status but have since been downgraded to junk.
The strategy of investing in fallen angels is based on the premise that the overly negative sentiment surrounding a downgrade into junk territory causes fallen angel bonds 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.
Tabula notes that fallen angels have historically delivered superior returns compared to the broader high yield market. The firm attributes this outperformance to characteristics such as a relatively higher credit rating (approximately 80% of fallen angels hold a BB rating compared to around 50% for the broader high yield market), lower default rates, and the fact that fallen angels tend to be bonds from larger, well-established businesses that are particularly focused on returning to investment grade in order to access cheaper borrowing.
Michael John Lytle, CEO of Tabula Investment Management, said: “When comparing fallen angels to the broader high yield universe, they offer higher credit quality with the potential to return to investment grade over time. Many fallen angels enter the high yield universe with a BB rating and don’t slip below that level. S&P’s long-term average global default rate is 0.59% for BB, compared to 25.7% for CCC and below, so the default rate for fallen angel exposure is likely to be significantly lower than for broad high yield exposure.”
Jason Smith, CIO of Tabula Investment Management, added: “In addition to their lower default risk, many fallen angels are also well positioned for upgrades. Fallen angels tend to be large, well-established names. Their business models and financing strategies are built around investment-grade borrowing rates, so their management has a strong incentive to address the issues that triggered the downgrade. Obviously, there is good potential for price appreciation if they rebound.”
Methodology
The fund is linked to the Bloomberg MSCI Global Corporate Fallen Angels Paris-Aligned Index which is based on a parent universe consisting of fallen angel bonds from developed market corporate issuers. Eligible bonds may be denominated in US dollars, euros, pound sterling, Swiss francs, Swedish krona, Norwegian krone, or Danish krone.
The original universe only includes fixed-rate issues with at least one year remaining until maturity, a credit rating between B- and BB+, and a minimum issue size of 150 million (USD, EUR, GBP, CHF).
It should be noted that the parent universe is ‘time-weighted’ in that it overweights newer fallen angels, an approach that seeks to increase exposure to potential rebounds (many fallen angels tend to bounce back strongly, performing well within the first 18 months since their downgrade).
The index construction methodology harnesses insights from MSCI ESG Research to exclude violators of UN Global Compact principles, companies embroiled in severe ESG-related controversies, and firms with business activities linked to weapons, tobacco, thermal coal, oil & gas, alcohol, adult entertainment, and cannabis.
The remaining constituents are then re-weighted using an optimization process, run on a monthly basis, that is designed to satisfy the requirements for an EU Paris Aligned Benchmark (PAB), aligning with a trajectory to limit global warming to 1.5°C above pre-industrial levels by 2050. Specifically, the index delivers an immediate 50% reduction in weighted average carbon intensity (based on Scope 1, 2, and 3 emissions) compared to the initial universe as well as a 7% annual decarbonization going forward.
The optimization also seeks to achieve secondary objectives such as increasing exposure to companies with higher ‘green’ revenues, minimizing turnover to a maximum of 2%, boosting yield-to-worst to a level that is higher than the parent universe, maintaining an option-adjusted duration within three months of the parent universe, and minimizing absolute deviations in constituent weights compared to the parent universe. These secondary objectives may be relaxed, however, to ensure compliance with the PAB requirement.
As of 22 June, nearly two-thirds (60.4%) of the index was allocated to issuers based in the US with the next-largest country exposures being Italy (9.6%), the UK (6.7%), and Sweden (6.0%).
Over four-fifths (81.8%) of the index was exposed to bonds rated BB with small allocations to the credit buckets of BBB (8.6%) and B (9.6%).
The index had an estimated 12-month yield of 8.4% and an average duration of 4.2 years.
The ETF comes with an expense ratio of 0.50% and is classified as an Article 9 product under the European Union’s Sustainable Finance Disclosure Regulation (SFDR).