By Meredith Larson, senior product manager of ETFs at VanEck.
VanEck: Fallen angels react to rising rates and tariffs
Fallen angel bonds are feeling the influence of US monetary policy and the geopolitical environment. Credit quality and sector weights have been key performance drivers so far in 2018 while somewhat offsetting one another. Fallen angel bond performance is mainly driven by higher average credit quality, sector differentiation, and potential value from discounted bonds as they are downgraded to high yield status.
Fallen angel bonds underperformed the broad high yield bond market by 0.5%, as of 31 May 2018 (-1.2% vs. -0.7%, respectively). After a strong start in January, their current 74% concentration in BB-rated bonds and associated interest rate duration proved challenging in the face of the Federal Reserve’s tightening monetary policy. Instead the lower duration, lower correlation single-Bs and CCCs have been the high yield outperformers since the end of 2017. Top fallen angel sector contributors year to date have been the overweight in energy and underweight in media. Main detractors have been positions and overweights in the basic industry (materials) and telecom sectors.
Higher credit quality
Credit spreads remain near multi-year lows at 363 points, ending May only five points wide versus the start of the year. Meanwhile, the US 10-year interest rate broke through 3% in April – a high not seen since 2011. The more comparable rate for high yield bonds is the US 5-year interest rate, which was up 46 basis points year to date at 2.66% and closing as high as 2.93% – a level not seen since 2009.
In this environment of modest overall moves in credit spreads and consistently rising interest rates, fallen angels’ higher quality composition has weighed on returns. However, when credit markets have deteriorated – i.e., when credit spreads widened significantly – the higher average BB-concentration has also historically resulted in less downside than the broader high yield bond market with its average 40% BB-concentration.
Fallen angel high yield bonds offered less downside when credit markets deteriorated
Source: VanEck.
While not always the case, fallen angel bonds have tended to outperform the broad high yield bond market, on average, in calendar years when credit spreads widened meaningfully, as well as in the subsequent recovery periods. The chart above shows fallen angel bonds outperforming broad market high yield bonds three out of the last six calendar years when credit spreads have widened.
This was most acutely seen in 2008, when fallen angels outperformed by 2.6% (-25.8% vs. -28.4%) as credit spreads widened by 1,212 points, and again in 2015 (-3.2% vs. -5.3%) when spreads widened by 191 points. Both 2008 and 2015 are instances that reflected value proposition as a key driver of returns, as these years represented the largest volumes of discounted fallen angel entrants, historically.
During the three calendar years in the chart above when fallen angel bonds underperformed the broad high yield bond market, the average relative return was -1.6%. This compares with the average +3.6% relative return in years with outperformance, helping to illustrate the strategy’s historical effectiveness.
Commodity sector bias
Fallen angels’ largest sector overweights relative to the broad high yield bond market are in the basic industry (materials) and energy sectors. As such, the fallen angel ETF and index tends to have greater sensitivity to commodity price movements.
In May, oil prices reached highs not seen since 2014, making the fallen angel energy sector the top performer year to date. Meanwhile, escalating trade tensions over potential tariff policies have contributed to price declines in materials. Fallen angels’ overweight in the basic industry sector has been the major driver of underperformance relative to the broad high yield bond market year to date.
Outlook
More price volatility in commodity sectors may ensue with increasing or subsiding trade tensions. Oil prices are likely to be responsive in the days leading up to and after the June OPEC meeting, when future output may be determined. However, despite these headline risks, fallen angels’ two largest sector biases may appeal to investors positively disposed to commodities for their potential diversification and pro-inflationary features.
US Treasuries yield curve’s flattening trend
Source: VanEck.
The Fed increased rates this month and signalled that additional hikes are coming in the second half of the year, raising concern over the flattening yield curve and its potential implications. Should markets deteriorate and decline, a fallen angel ETF presents a higher quality option for high yield investors to consider. Lower rated high yield bonds have tended to deteriorate more than higher rated high yield bonds when credit spreads widened significantly. In addition, a declining credit market could precipitate new fallen angel entrants, which may present new value opportunities for this strategy.
VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL) consistently outperformed peers
Source: VanEck.
VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL) received an overall five-star rating within the Morningstar high yield bond category based on total return as of 31 May 2018. Past performance is no guarantee of future results.
(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)