Fallen Angels: No Time Like the Present
The risk/return profile of the Bloomberg Barclays US HY Fallen Angel 3% Cap Index (fallen angels) has been impressive relative to the broad high yield universe and other major asset classes. In our view, the key advantage of a dedicated fallen angel strategy is the potential to earn true structural alpha by exploiting the oversold prices that occur after investment grade bonds are downgraded to high yield.
We believe this year will be an auspicious entry point for a fallen angel allocation due to the effects of the severe economic downturn and US credit market dislocations. Some key driving factors in 2020 include:
- Potentially record downgrades increases opportunity set
- Option-adjusted spreads (OAS) are wide
- The Federal Reserve’s bond-buying program now includes fallen angels
Downgrade Activity in 2020 Likely to Dwarf Prior Years
After several years of modest fallen angel creation, corporate debt downgrades have begun to accelerate. Even prior to the economic dislocations caused by the COVID-19 pandemic, downgrades were expected to grow. Against a backdrop of extremely volatile economic activity, however, many issuers’ ability to keep their investment grade rating appears in jeopardy.
$150 billion of bonds have already entered the fallen angel universe in 2020, a figure that exceeds all calendar years since the 2005 inception of the Bloomberg Barclays US HY Fallen Angel 3% Cap Index. Our review of rating agency metrics suggests potential for another $500 million in downgrades.
Downgrade History - Amount Outstanding
As of April 30, 2020. Source: Bloomberg
An increase in downgrades helps to augment the structural inefficiencies embedded in the market in two ways. First, the supply/demand imbalance for new fallen angels should lead to greater price distortions. In our view, forced selling by investment grade managers, combined with the high yield market’s inability to digest the new supply, will drive new fallen angel prices further below their fundamental value, offering investors the opportunity to realize higher alpha when equilibrium is restored. Second, the increased supply creates a larger opportunity set, allowing for a more diversified portfolio with the potential for improved risk/return profile.
Wide OAS Spreads
The OAS of corporate bonds over Treasuries is frequently used to measure the expected excess return above Treasuries in order to justify additional risk. It is a common measurement of investors’ risk appetite.
Like many risk assets, fallen angel prices fell sharply during March as the COVID-19 pandemic resulted in severe downward revisions to 2020 global growth forecasts and dramatically lower corporate earnings forecasts. OAS spreads reached 955 basis points at the end of March, a level not seen since the Global Financial Crisis. Though spreads have narrowed somewhat since, they remain firmly above their average of 493 basis points since the fallen angel index began in 2005.
Federal Reserve Support
On April 9, the Federal Reserve (Fed) announced plans to expand its bond-buying program to include recent fallen angel bonds—in the primary and secondary markets—and high yield exchange-traded funds (ETFs). The decision augmented the Secondary Market Corporate Credit Facility that was created to provide liquidity in the investment grade market.
The expansion into high yield includes many high-profile companies that were investment grade as of March 22 and have subsequently become fallen angels (as long as they are still rated BB-/Ba3 or better). In our view, the Fed’s foray into high yield in general and fallen angels in particular should provide a number of benefits. At a high level, purchasing ETFs will provide positive sentiment for valuations and liquidity across the broader high yield market and specifically in the fallen angel sector. By pledging to purchase bonds in both the primary and secondary markets, the Fed is playing a market-making role by supporting the ability of borrowers to raise cash.
A Silver Lining
Capturing structural alpha is attractive in normal markets, but the near-term environment will be anything but normal. However, we believe the ramifications from the COVID-19 pandemic will benefit the fallen angel universe. The likelihood of a record year for downgrades, attractive valuations, and explicit support from the Fed increase the potential for generating attractive total and risk-adjusted returns.
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
Mellon Investments Corporation (“Mellon”) is a registered investment advisor and subsidiary of The Bank of New York Mellon Corporation (“BNY Mellon”). Any statements of opinion constitute only current opinions of Mellon, which are subject to change and which Mellon does not undertake to update. This publication or any portion thereof may not be copied or distributed without prior written approval from the firm. Statements are correct as of the date of the material only. This document may not be used for the purpose of an offer or solicitation in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or not authorized. The information in this publication is for general information only and is not intended to provide specific investment advice or recommendations for any purchase or sale of any specific security. Some information contained herein has been obtained from third party sources that are believed to be reliable, but the information has not been independently verified by Mellon. Mellon makes no representations as to the accuracy or the completeness of such information. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment and past performance is no indication of future performance. The indices referred to herein are used for comparative and informational purposes only and have been selected because they are generally considered to be representative of certain markets. Comparisons to indices as benchmarks have limitations because indices have volatility and other material characteristics that may differ from the portfolio, investment or hedge to which they are compared. The providers of the indices referred to herein are not affiliated with Mellon, do not endorse, sponsor, sell or promote the investment strategies or products mentioned herein and they make no representation regarding the advisability of investing in the products and strategies described herein. Please see mellon.com for important index licensing information.