Why bond investors may find sanctuary in ‘fallen angels’


Karen Veraa, CFA Aug 30, 2022

KEY TAKEAWAYS

KEY TAKEAWAYS

  • Fallen Angel bonds have outperformed both the overall high yield market and investment grade bonds over the past decade on a total-return basis.1
  • The global pandemic created a large new group of ‘fallen angels’, many of which could now be poised to return to investment grade status, aka “rising stars.”2
  • If  a portion of fallen angels return to investment grade status, targeted iShares ETFs have the potential to offer investors income with reduced credit risk.

WHAT ARE FALLEN ANGEL BONDS?

WHAT ARE FALLEN ANGEL BONDS?

Bond yields have risen since the Federal Reserve started raising rates in March 2022.3 But the economy has been slowing and we expect volatility to remain elevated, as detailed in the iShares Midyear 2022 Investor Guide. In this environment, bond investors may be looking for income without taking on too much risk. A corner of the fixed income market known as “fallen angels” may provide the solution.

Bonds that were originally investment grade — meaning they are rated triple-B or higher — but later get downgraded to high yield, are commonly known as fallen angels. Investors who then purchase these bonds may benefit from the “fallen angels’ premium,” which is the historic outperformance of these bonds relative to the broader high yield bond market.4

THE GLOBAL PANDEMIC CREATED MORE FALLEN ANGELS

THE GLOBAL PANDEMIC CREATED MORE FALLEN ANGELS

As the global pandemic hit and the world sheltered in place, businesses were forced to close, tourism shut down, and energy prices initially plummeted. Credit rating agencies analyzed this information and determined that some companies were at risk of being unable to make coupon payments or repay investors when their bonds mature. Over the course of 2020, 31 issuers across a wide range of industries — including airlines, rental car companies and energy drillers — lost their investment grade rating and joined the high yield universe. This group of “fallen angels” added $169 billion of notional debt to the total high yield universe market.5

By the end of 2020, the size of the fallen angel universe had more than doubled from pre-pandemic levels to $287 billion — rising from under 10% to more than 15% of the total high yield universe market.6 iShares Fallen Angels ETF (FALN) has increased in assets to $2.8 billion from $194 million over the two years ending June 30, 2022.7

Fallen angels share of full high yield universe

Bar chart showing the showing the growth of ‘fallen angel’ bonds as a percentage of the entire high yield market.

Source: Bloomberg US High yield Fallen Angel 3% Capped Index as of 6/30/2022 relative to the Bloomberg US Corporate High Yield Index.

Past performance does not guarantee future results.

Chart description: Bar chart showing the showing the growth of ‘fallen angel’ bonds as a percentage of the entire high yield market.


BOND INVESTORS FIND SANCTUARY IN FALLEN ANGELS

BOND INVESTORS FIND SANCTUARY IN FALLEN ANGELS

As the chart below illustrates, fallen-angels have outperformed both the overall high yield market and investment grade bonds over the past decade. The fallen angel price cycle typically goes like this: Fixed income investors typically stick to either investment grade bonds or seek higher-yielding junk bonds. Because many investment grade accounts can’t own high yield bonds, the prices tend to suffer just before the initial fall from investment grade status, resulting in a rebound soon after the downgrade. Over time, the issuer may improve its finances and get upgraded back to investment grade, resulting in a further price spike as the bonds become eligible again for investment grade investors. Historically, at this point, these bonds have been called “rising stars”.

10-Year total return of fallen angels vs. high yield and investment grade

Chart showing the fallen angels have outperformed over a 10-year total return period when compared to their high yield and investment grade counterparts.

Source: BlackRock as of 6/30/22. Fallen Angels is the Bloomberg US High Yield Fallen Angel 3% Capped Index, Broad High Yield is the Bloomberg US Corporate High Yield Index, and IG Corporate is the Bloomberg US Corporate Index.

Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Chart description: Chart showing the fallen angels have outperformed over a 10-year total return period when compared to their high yield and investment grade counterparts.


Rating agencies are now upgrading more issuers back to investment grade. In the first half of 2022, about $69 billion of high yield bonds were upgraded to investment grade.8

If the fallen angels return to investment grade status, targeted iShares ETFs still have the potential to pursue income and exposure to future rising stars.

THE REOPENING TRADE: RISING STARS GAIN THEIR WINGS

THE REOPENING TRADE: RISING STARS GAIN THEIR WINGS

The iShares Fallen Angels ETF (FALN) has a high proportion of its holdings in energy companies and more cyclical sectors, which combined to represent 44% of the total fallen angel universe as of June 30.9 With rising energy prices and travel resuming, the revenue streams of many fallen angels appear set to improve.

That said, fallen angels tend to have more interest rate risk than traditional high yield bonds. Because they started out as investment grade credits, fallen angels’ bonds tend to have longer maturities vs. debt originally issued as high yield. As a result, bondholders are more susceptible to changes in interest rates over longer periods of time. That can be beneficial in an environment of falling rates but has hindered the performance of fallen angels since the Fed started raising rates in March 2022.10

When a fallen angel rises back to investment grade, it typically joins the BBB-rated market, the largest rating segment in the investment grade universe.11 In May 2021, BlackRock launched the iShares BBB Rated Corporate Bond ETF (LQDB), the first vehicle of its kind to provide targeted exposure to BBB-rated investment grade corporates.12 For investors who seek higher-quality fixed income, and the potential for higher yields than the broader investment grade sector, LQDB can help provide that exposure.

iShares Bond ETFs offer multiple ways to gain exposure to trends in the bond market. As yields move higher on both investment grade and high yield bonds, investors can position to earn more. iShares Fallen Angels ETF (FALN) and iShares BBB Rated Corporate Bond ETF (LQDB) give investors the opportunity to access hundreds of these bonds at a low cost.

Karen Veraa, CFA

Karen Veraa, CFA

Head of U.S. iShares Fixed Income Strategy

Connor Stack

Vice President, Fixed Income Product Strategy

Contributor

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