ANGL - Yields Remain Attractive Even As Spreads Grind Tighter

2023-08-17 01:15:00 ET

Summary

• While growing confidence in better-than-expected corporate earnings, resilient U.S. growth and a moderation in inflation have led to tighter fallen angel spreads, yields remain attractive.
• Fallen angels slightly underperformed the broader high yield market by 0.16% in July (1.26% vs. 1.42%).
• Year-to-date, fallen angels are lagging by 0.73%, (6.19% vs 6.92%). This marks a significant shift from a year ago when fallen angels had a return of -12.35% for the first seven months of 2022.

While growing confidence in better-than-expected corporate earnings, resilient U.S. growth and a moderation in inflation have led to tighter fallen angel spreads, yields remain attractive.

Fallen angels (as represented by the ICE US Fallen Angel High Yield 10% Constrained Index, “H0CF”) slightly underperformed the broader high yield market (as represented by the ICE BofA US High Yield Index, “H0A0”) by 0.16% in July (1.26% vs. 1.42%).

Year-to-date, fallen angels are lagging by 0.73%, (6.19% vs 6.92%). This marks a significant shift from a year ago when fallen angels had a return of -12.35% for the first seven months of 2022. Underperformance was driven by a rally in lower quality bonds amid a rally in riskier credit, which have lower representation among fallen angels.

In July, fallen angel spreads tightened by 17bps, dipping below the 300 mark, a level that hadn’t been seen since March 2022 when spreads reached a low of 262bps.

This tightening can be attributed to investors' growing confidence in better-than-expected earnings, resilient growth in the U.S., and a moderation in inflation. The U.S. Federal Reserve (Fed) raised rates by 0.25% in July, resulting in a target rate of 5.25% to 5.50%, and government bond yields increased; however, this was offset by spread tightening.

In terms of fund flows, high yield corporates witnessed approximately $1 billion in inflows. , There was also notable movement along the yield curve, with over $9 billion flowing into intermediate duration and approximately $6 billion into long duration bonds.

Rates dominating spreads?

Historically, spreads have played a more prominent role in high yield investments, with a long-term average of 500 basis points – a very meaningful contributor to overall yield.

However, the recent increase in rates (from 0% to 5.5%, based on Fed Funds) has driven overall yields to historically high levels (fallen angels yielding 7.25%, above the all-time average and median), making rates a more significant contributor to overall yields (and thus, returns) relative to history. As a percentage of yield, spreads are notably low, at 39% compared to the longer-term average of 64%.

Although overall yields are high, currently tighter than average spreads makes spread widening a potential concern if the U.S. economy experiences a slowdown in growth and a weakening credit environment.

However, investor confidence in the concept of a soft landing has grown, supported by positive economic data highlighting a robust labor market and cooling inflation.

This optimism is boosting interest in high carry/high yield trades. Despite relatively low spreads, the high overall yield helps mitigate potential losses from spread widening through a high level of carry.

In addition, investors would generally expect interest rates to decline in a spread widening environment where they may flock to the safety of government bonds. In such an environment, and given the current valuations in high yield, we believe higher quality bonds may fare better than lower quality bonds.

Currently, spreads between BB and Single-B rated bonds have compressed and are now below their 3-year, 5-year and 10-year respective averages. This suggests that in a deteriorating spread environment, lower quality bonds have a greater scope for underperformance.

We also note that high overall yields have resulted in an attractive payoff profile, as measured by the convexity of the fallen angel index. In other words, fallen angels have a higher potential for upside than downside, and to a greater degree than they have historically.

This is due to the influence of rates on returns. The convexity of fallen angels is at its lowest point since July 2008, making a decrease in rates more impactful on price increases than an increase in rates on price decreases.

Overall, the prevailing factors influencing the market dynamics suggest that while rates are currently in the driver's seat for bond returns, the potential for spread widening cannot be disregarded. However, overall yield levels are undoubtedly attractive relative to history and provide significant downside protection against a spread widening scenario.

Fallen Angel Spread as % to Yield

Source: ICE Data Services, VanEck. OAS = Option-Adjusted Spread (OAS); YTW = Yield-to-Worst (YTW). Please see definition for these and other terms referenced herein in the disclosures and definitions portion of this blog. Past performance is no guarantee of future results. Index performance is not representative of fund performance. It is not possible to invest in an index.

Fallen Angels Overall Statistics: Fallen angels yields decreased in July by 10bps to 7.25 and broad HY yields by 20bps to 8.36, while the 10Y yield increased by 16bps to 3.97. Spreads for both tightened in July and the fallen angel market value declined as another issuer exited the index during the month.

Source: ICE Data Services, VanEck. Fallen Angels: ICE US Fallen Angel High Yield 10% Constrained Index. Broad HY: ICE BofA US High Yield Index. OAS refers to “option-adjusted spread.” Please see definition for this and other terms referenced herein in the disclosures and definitions portion of this blog. Past performance is no guarantee of future results. Index performance is not representative of fund performance. It is not possible to invest in an index.

New Fallen Angels : No new fallen angels in July.

Source: ICE Data Services, VanEck. Fallen Angels: ICE US Fallen Angel High Yield 10% Constrained Index. Past performance is no guarantee of future results. Not a recommendation to buy or sell any of the names/securities mentioned herein. Index performance is not representative of fund performance. It is not possible to invest in an index.

Rising Stars: One issuer exited the index in July, Western Digital Corporation ( WDC ), as S&P upgraded its senior secured notes from BB to BBB- following an amendment to its credit agreement which resulted in the notes becoming secured by substantially all of the assets of the issuer.

It entered the index in November 2022 at $76.91 and weight of 0.99% and for the eight months in the index, its total return was 2.07%, which lagged the Tech’s sector total return (6.36%) for the same period.

The Tech sector within the fallen angel index outperformed broad high yield and the fallen angel index for the same eight months (6.21% for fallen angels and 6.11% for broad high yield). Approximately one-third of the index has exited as rising stars this year.

Source: ICE Data Services, VanEck. Past performance is no guarantee of future results. Not a recommendation to buy or sell any of the names/securities mentioned herein. Index performance is not representative of fund performance. It is not possible to invest in an index.

Fallen Angels Performance by Sector: July was the first month in a while with limited sector changes. The Tech sector saw the largest change, decreasing 0.91% from June, as it had the rising star. Other sectors with significant changes include Energy (+0.36%) and Banking (+0.25%).

No sector saw wider spreads in July, three were unchanged and the remaining 14 saw tightening compared to June. Banking tightened the most (0.97%), followed by the Financial Services sector (0.57%), both of which were the top performing sectors in July (7.73% for Banking; 2.56% for Financial Services).

The Banking sector return was due to PacWest Bancorp ( PACW ) and recent fallen angel Western Alliance Bancorp ( WAL ), as their spreads tightened by 806bps and 152bps, respectively, and prices increased by 64% and 10%, respectively.

Both issuers were part of the banking mini-crisis earlier in the year with bond prices trading in the low $30s for PacWest and mid-to-low $40s for Western Alliance at the beginning of April. In terms of sector attribution vs broad HY, the Banking and Energy sectors within fallen angels were the top two contributors.

Source: ICE Data Services, VanEck. Fallen Angels: ICE US Fallen Angel High Yield 10% Constrained Index. Not intended as a recommendation to invest or divest in any of the sectors mentioned herein. Index performance is not representative of fund performance. It is not possible to invest in an index.

Fallen Angels Performance by Rating: No major changes in ratings composition in July. In terms of attribution vs. broad high yield in July, higher quality ((BB)) has positively contributed, but single-B and CCC & lower rated bonds have detracted from performance.

It is worth noting that broad high yield has approximately 50% allocated to single-B and lower rated bonds so far this year while that figure is close to 15% for fallen angels.

Source: ICE Data Services, VanEck. *Does not have securities for all months of selected period. Returns are based on partial period data. Fallen Angels: ICE US Fallen Angel High Yield 10% Constrained Index. Past performance is no guarantee of future results. Index performance is not representative of fund performance. It is not possible to invest in an index.

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.

Yield-to-Worst (YTW) : This is the lowest yield that can be received on a bond that fully operates within the terms of its contract without defaulting.

Option-Adjusted Spread (OAS): The measurement of the spread of a fixed-income security and the risk-free rate which is then adjusted for an embedded option.

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.

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

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