JNK - Don't Call Me ANGL

2023-08-22 05:03:53 ET

Summary

• Fallen Angel bonds are those securities that are investment grade when issued.
• They are subsequently downgraded when the issuer runs into financial troubles.
• Today, we cover an ETF that caters to the buyers of these bonds.

When an investment grade bond is downgraded to junk status, it is called a Fallen Angel. The downgrade occurs when the issuer suffers from financial woes, putting into doubt their ability to service their debt obligations. In the time leading up to the downgrade and in anticipation of it, these bonds typically experience heavy selling pressure. This is partly due to certain institutional investors like pension funds being prohibited from holding junk bonds, also known as high yield bonds. Investors not bound by prohibitive rules pertaining to speculative bonds, and those that believe that the fallen issuer has a fair chance of recovering, step in after the selling pressure as they see a bargain. The price decline gives him a higher yield to maturity or YTM from an issuer that was recently deemed to be investment grade. Often times, on the occurrence of the downgrade itself, these bonds recover some of their value as they tend to be oversold in anticipation of the event. That the issue is at the top rung of junk, does not hurt and gives the buyers a wide margin of safety in the chance that all hell breaks through. Retail investors cannot spread themselves too thin, as their resources are limited. Directly buying individual issues may prove too expensive and cumbersome a task. This crowd has the option to buy exchange traded funds or ETFs dedicated to these types of securities, one of which we will discuss today.

The Fund

VanEck Fallen Angel High Yield Bond ETF ( ANGL ) pursues the performance of ICE US Fallen Angel High Yield 10% Constrained Index, net of expenses. ANGL is a passive ETF and as such it does not aim to beat the index or deviate from its investment objective in response to the market conditions. It would continue holding on to a security, even if the financial troubles were exacerbated, as long as it was still in the index. This ETF's unitholder pays 0.35% in management fees annually, whereas the benchmark index has no expenses. Even taking that handicap into consideration, the ETF has not done its job too well.

In fact, over the longer timeframes, the underperformance is far more than what one would expect taking into account the ETF expenses. But investors must keep in mind that in this arena, there are few products that cater to their needs. So you have few choices with which to try and generate alpha. Normally, ANGL invests at least 80% of its total assets in securities from the index. The index comprises USD denominated bonds that are currently rated below investment grade, but were rated investment grade at the time of their issuance. We can see below that the portfolio composition adheres to that in most parts.

The 4.34% in investment grade securities could be a result of a recent upgrade, which likely exits the portfolio in the next rebalancing. While the bonds must be issued in the U.S. domestic market, they can originate from both U.S. or non-U.S. issuers.

In case of a default, the concerned security is removed from the index at the end of the month it happens. While ANGL holds securities with maturities of more than 30 years, majority of its portfolio matures in 10 years or less. The average maturity at the portfolio level is 9.75 years.

Consumer cyclicals, technology and energy form more than 50% of the issuers.

If we add the fourth in the list, the industrial sector, we have the top four volatile sectors in the market, which makes their presence in a Fallen Angels portfolio understandable. The banking crisis of early 2023 helped the financial sector achieve a top 5 ranking above. On the other hand, we have the more even keeled sectors, like utilities, healthcare and consumer non-cyclicals and they form a lower proportion of the ANGL portfolio.

In terms of the collective earning capacity of the portfolio, the yield to maturity is 7.68%, with the yield to worst coming in very close at 7.60%.

After accounting for expenses (around 0.35% as noted earlier in this piece), ANGL has around 7.25% available to distribute to its unitholders. Based on its more recent distribution of 13 cents, and the current price of $27.36, this fund yields around 5.70%. This tells us ANGL has room to increase its distributions. YTM is a leading indicator and the growth in payouts occurs in the subsequent months and is gradual. Another point to note from above is the sensitivity of these funds to interest rates and that is reflected in the effective duration of 4.89 years. This generally indicates the extent to which the portfolio will decline in value in response to a 100 basis points increase in interest rates and vice versa. This is a decent duration, such that you can make a good bang for your buck, without taking on too much interest rate risk.

Verdict

Fallen Angel bonds typically tend to do better than the legacy high yield bonds because of their unique characteristic of straddling the investment grade and junk world. We can see that in ANGL's outperformance against SPDR Bloomberg High Yield Bond ETF ( JNK ).

The latter has a lower duration (3.57 years), a higher yield to maturity (8.97%) and an overall lower average portfolio maturity (5.03 years). JNK's performance in 2023 is better, but not by much.

We passed on JNK a year ago as buying into an ETF exclusively holding junk bonds was not necessary, when we could make close to the high yield offered by these from quality preferred shares. Investors with a liking for high yield bonds can however consider ANGL as the lessor of the two risky vehicles. But one should not think the term "Angel" here refers to a safe investment that would give you high yield with low volatility.

For those wanting higher yield, one alternate choice that is even less risky would be a term maturity high-yield fund like iShares iBonds 2024 Term High Yield and Income ETF (BATS: IBHD ). That way you are really taking advantage of the low probability of default by even weaker borrowers over shorter time frames.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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