FRCJL - What Can Drive Fallen Angel Performance From Here?

2023-09-13 12:00:00 ET

Summary

• Fallen angels underperformed the broader high yield market in August and year-to-date.
• High yield corporates experienced outflows, while Treasury products saw inflows in August.
• Several potential scenarios could reignite price performance for fallen angels, including weakening corporate profits and a more risk-averse environment.

Several potential scenarios may reignite price performance as a driver of fallen angel outperformance, driven by their higher quality and the technical effect of buying oversold downgraded bonds.

Fallen angels (as represented by the ICE US Fallen Angel High Yield 10% Constrained Index, “H0CF”) underperformed the broader high yield market (as represented by the ICE BofA US High Yield Index, “H0A0”) by 0.25% in August (0.04% vs 0.29%). Year-to-date, fallen angels are lagging by 0.99% (6.23% vs 7.22%). Lower credit quality issuers continue to outperform due to robust U.S. growth data and better-than-expected earnings with the CCC & Lower US HY Index returning 13.62% YTD. Goldman Sachs has reduced its 12-month U.S. recession probability to 15%, crediting the positive inflation news and labor market data. As a higher-quality strategy with a significantly greater tilt to BB rated bonds versus the broad market, fallen angels have not participated in the recent rally to the same extent as the lower-quality broad high yield market.

High Yield YTD Total Return

In terms of fund flows, high yield corporates have experienced approximately $1bn in outflows while Treasury products added approximately $9bn just in August. Short duration saw outflows, but the other categories (Floating, Ultra Short, Intermediate and Long) registered inflows.

Can price returns drive outperformance going forward?

The price return of fallen angels has been a key differentiator versus broad HY from a total return perspective, driven by the systematic purchases of oversold/undervalued bonds that have been downgraded to high yield and have tended to recover in the months after being downgraded.

Price return this year, however, has been a detractor. Two primary factors contributing to this decline are the scarcity of fallen angels and their longer duration. For instance, even though rising stars have historically boosted performance during periods of low downgrade volumes, the extended duration of rising stars in 2023 (accounting for 35% of the year's starting index value) has meant that they have not been additive to performance this year. With an average price of $88.75, fallen angels now have a lower average price compared to the broader high-yield market.

We believe there are several potential related scenarios that could reignite price performance as a driver of outperformance, as seen historically. First, corporate profits and financial positions might weaken due to rising debt costs and the possibility of an economic slowdown, leading to wider credit spreads. Lower-quality issuers, with limited capacity to refinance and sustain higher interest costs, may be particularly vulnerable. Given that credit spreads are currently near their tightest levels of the year, there's room for significant widening if a less favorable economic environment materializes. In a scenario where credit quality deteriorates and spreads widen, higher-quality bonds may outperform, potentially favoring fallen angels on a relative basis.

Similarly, in a more risk-averse environment, bond yields are likely to decrease from their current elevated levels, which could benefit longer-duration fallen angels compared to the broader high-yield market, all else equal. More importantly, a scenario of credit weakness could lead to a higher volume of new fallen angels. While we haven't witnessed a significant wave of downgrades since 2020, credit rating downgrades tend to lag behind changes in fundamentals. Although the overall credit market remains relatively robust, it's worth noting that credit metrics are beginning to reflect lower profits and increased funding costs, and defaults among highly leveraged borrowers are on the rise. According to J.P. Morgan, the value of defaults and distressed exchanges year-to-date is already approaching the eighth highest annual amount on record, with the potential to become the third-largest annual total by year-end. While it's impossible to predict the exact timing, given these broader dynamics, it's difficult to envision a scenario where downgrades do not increase. Historically, fallen angel price returns have been at their strongest, and their outperformance against the broader high-yield market has been most pronounced when a significant number of downgraded bonds, typically deeply discounted, enter the market.

Fallen Angels Overall Statistics

Fallen angels yields increased by 20bps to 7.45 and broad HY yields by 12bps to 8.48 in August. The 10Y yield increased by 12bps to 4.09 but it saw a dip at the end of the month from 4.34. Spreads saw some widening while duration was almost unchanged. The fallen angel market value has declined with almost 3 times more rising stars than fallen angels so far this year. Defaults in the high yield market have begun to pick up and fallen angels have seen 0.50% default par (approx. $628m in par amount for just one issuer) vs 0.97% default par (approx. $13,368m in par amount for 11 issuers) in broad HY.

New Fallen Angels

Two fallen angels were added in August, both in the banking sector: Associated Banc-Corp ( ASB ) and Valley National Bancorp ( VLY ) Tier 2 notes. These two were part of the broader banking sector downgrade by the rating agencies warning that funding risks and commercial real estate exposure may bring weaker profitability amid higher for longer interest rates. Over the last 12 and six months, Associated Banc-Corp posted price returns of -1.34% and -3.25%, respectively, while Valley National Bancorp posted -9.76% and -11.87%, respectively. With these latest additions, fallen angels account for 11.84% of index weight YTD.

Rising Stars

One issuer exited the index in August, Howmet Aerospace ( HWM ), as Fitch upgraded it to ‘BBB’. Howmet has been steadily improving its profitability, which is supported by the company's leading and defensible market position and differentiated technology portfolio. Howmet Aerospace was part of the Covid wave of downgrades in April 2020, entering the index at $97.24 with a 1.30% exposure; it now exits at $99.55 and 2.04%. Over the last 12 months, Howmet Aerospace posted a price return -0.02% vs 1.82% for the broad high yield market, however, during its time in the fallen angel index, it posted price return of 2.38% vs 0.30% for broad high yield. Rising stars continue to be one of the main topics this year, even as their outperformance over broad HY before exiting the fallen angel index has been lower than the historical average as mentioned above.

Fallen Angels Performance by Sector

There were no significant sector composition changes in August. The top three performers were Telecom (+2.83%), Consumer Goods (+1.39%) and Real Estate (1.33%) which were also the only sectors to see price increases in August, while the worst performers were Retail (-1.52%), Capital Goods (-1.22%) and Insurance (-1.15%). Leisure saw its exposure decreased as a large Las Vegas Sands issue was removed due to its maturity being shorter than 12 months away. Spreads widened in most sectors and prices decreased in all but three sectors, which were the same as the top three performers mentioned above. As of month-end, 63% of fallen angels are now trading in the $80s, 37% in the $90s and no sector is above par.

Fallen Angels Performance by Rating

The BB-rated bucket was the only ratings category that saw spreads widen and price fall, thus the negative return.

Important Definitions and Disclosures

Please note that VanEck may offer investments products that invest in the asset class(es) or industries included in this blog.

This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities, financial instruments or digital assets mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, tax advice, or any call to action. Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results, are for illustrative purposes only, are valid as of the date of this communication, and are subject to change without notice. Actual future performance of any assets or industries mentioned are unknown. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. VanEck does not guarantee the accuracy of third party data. The information herein represents the opinion of the author(s), but not necessarily those of VanEck or its other employees.

A fallen angel bond is a bond that was initially given an investment-grade rating but has since been reduced to junk bond status.

High yield bonds may be subject to greater risk of loss of income and principal and are likely to be more sensitive to adverse economic changes than higher rated securities.

A rising star is a high yield bond that is upgraded to investment grade.

Duration is an estimate of how much the value of a bond portfolio would be affected by a change in prevailing interest rates. The longer a portfolio’s duration, the more sensitive it is to changes in interest rates.

There are inherent risks with fixed income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer duration fixed-income securities and during periods when prevailing interest rates are low or negative.

Index returns are not Fund returns and do not reflect any management fees or brokerage expenses. Certain indices may take into account withholding taxes. Investors cannot invest directly in the Index.

ICE BofA US High Yield Index (H0A0, “Broad HY Index”), formerly known as BofA Merrill Lynch US High Yield Index prior to 10/23/2017, is comprised of below-investment grade corporate bonds (based on an average of various rating agencies) denominated in U.S. dollars.

ICE US Fallen Angel High Yield 10% Constrained Index (H0CF, “Fallen Angels Index”) is a subset of the ICE BofA US High Yield Index and includes securities that were rated investment grade at time of issuance.

Fallen Angel U.S. High Yield index data on and prior to February 28, 2020 reflects that of the ICE BofA US Fallen Angel High Yield Index (H0FA). From February 28, 2020 forward, the Fallen Angel U.S. High Yield index data reflects that of the ICE US Fallen Angel High Yield 10% Constrained Index (H0CF). Fallen Angel U.S. High Yield index data history which includes periods prior to February 28, 2020 links H0FA and H0CF and is not intended for third party use.

ICE Data Indices, LLC and its affiliates (“ICE Data”) indices and related information, the name "ICE Data", and related trademarks, are intellectual property licensed from ICE Data, and may not be copied, used, or distributed without ICE Data's prior written approval. The licensee's products have not been passed on as to their legality or suitability, and are not regulated, issued, endorsed, sold, guaranteed, or promoted by ICE Data. ICE Data MAKES NO WARRANTIES AND BEARS NO LIABILITY WITH RESPECT TO THE INDICES, ANY RELATED INFORMATION, ITS TRADEMARKS, OR THE PRODUCT(S) (INCLUDING WITHOUT LIMITATION, THEIR QUALITY, ACCURACY, SUITABILITY AND/OR COMPLETENESS).

All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future results.

© Van Eck Securities Corporation, Distributor, a wholly owned subsidiary of Van Eck Associates Corporation.

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

For further details see: