Fallen Angels: The Last Free Lunch
A defining characteristic of markets is that structural alpha opportunities are arbitraged away over time. What if there was an area where market mechanisms actually bolstered a structural alpha opportunity? We think this would be the last free lunch for investors. Welcome to the world of fallen angels—investment grade credits that have been downgraded to high yield.
Unlike their namesakes that were expelled from heaven, fallen angels, as represented by the Bloomberg Barclays US High Yield Fallen Angel 3% Capped Index, have outperformed the major asset classes since the index was introduced in January 2005. The primary reason for fallen angels’ strong performance is that they enter the index at oversold prices. Selling by investment grade managers, both in anticipation of and after a downgrade, distorts prices relative to original-issue high yield bonds. Our research shows that fallen angels enter the index 150 basis points cheaper than high yield peers, on average.
While a fallen angel allocation may appear straightforward, there are impediments to successfully capturing the risk premium, resulting in few investment vehicles devoted to the asset class. A narrow universe, high trading costs, and low dealer inventory create significant implementation challenges. In our view, a strategy that exploits the mispricings among fallen angels and minimizes trading costs can overcome these obstacles.