Fallen Angels: The Party is Just Getting Started
Despite the recovery in risk assets, fundamentals suggest that the night is still young for fallen angels.
Over the past two months through May 31, 2020, the Bloomberg Barclays US High Yield Fallen Angel 3% Capped Index (FA Index) rose 17.10%, handily outperforming the 9.11% gain for the Bloomberg Barclays US Corporate High Yield Index (HY Index). The outperformance of the FA Index was so pronounced and so dramatic, it is natural for investors to wonder if they missed the party.
Worry not! In our view, the party is just beginning. Please allow us to elaborate.
Since its inception in October 2004 through May 31, 2020, the FA Index has produced an annualized total return of 9.01% versus 6.60% for the HY Index, for an annualized outperformance of 2.41%. Since the FA Index typically carries a longer duration than the HY Index (5.65 and 3. 66 years, respectively, as of May 31), a natural question arises. What portion of this outperformance comes from the secular decline in interest rates? A closer look at the 2.41% outperformance reveals that the spread component (excess return over Treasuries) was in fact the primary driver, explaining 76% of the outperformance, while the impact of rates was minimal.
Source: Bloomberg as of 5/31/20.
What is interesting to us is that so far in 2020, the strong outperformance of the FA Index has been driven entirely by rates, not the spread. Year-to-date through May 31, the FA Index remains in the red with a return of -1.83%. However, with the HY Index down -4.73%, the FA Index has outperformed by 2.90%. While this 2.90% outperformance is consistent with the longer-term results, the key difference in 2020 is that ALL of the 2020 outperformance through May 31 was due to rates. The spread contribution has actually produced negative returns year to date.
Source: Bloomberg as of 5/31/20.
For full disclosure, the spread contribution has already begun to show signs of life since the news of the Fed stepping in to support credit markets in late March hit the markets. Indeed, during April and May, the spread component of the FA Index rallied 16.60% to recoup much of its -22.38% decline during the first quarter. By comparison, the broad HY Index spread component rallied 8.65% and recovered a little more than half of the -15.45% fall in the first quarter. While the spread rally has already gotten under way, we believe it can continue for a while. In our view, there are at least two reasons for this.
First, 2020 is expected to see the greatest volume of downgrade activity in history, which presents an unusually strong opportunity for harnessing structural alpha. As we noted in our August 2019 paper Fallen Angels: The Last Free Lunch, the primary reason for the notable outperformance of the FA Index is that fallen angels typically enter the index at oversold (often significantly oversold) prices vs BB-rated peers. 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 FA Index 150 basis points cheaper than high yield peers, on average. This forced selling and ensuing rally is among the primary reasons the FA Index has outperformed the HY Index. We expect up to $500 billion of investment grade bonds at risk of downgrade to high yield (fallen angels) in 2020, which would dwarf any prior yearly downgrades. This technical selloff will continue to provide a boost to fallen angels and present ongoing opportunity to pick up alpha.
Downgrade History - Amount Outstanding
Source: Bloomberg as of 4/30/20.
Second, and perhaps a bit more subtle, the spread component takes time to unfold. As the “J-curve” below shows, subsequent to formal downgrade, the excess return of the average fallen angel bonds continues to outperform for 12 months or more. So far in 2020, the bulk of the downgrades occurred within the past 2-3 months with still a larger number on downgrade watch (meaning they have yet to be downgraded). In our view, this presents an additional alpha opportunity as we believe the spread really can be sustained into the near future.
Cumulative Return: Fallen Angel Simple Average vs. BB Index
(Oct 2004 - Dec 2019)
Source: Bloomberg. Information shown represents all bonds that were downgraded from investment grade (as measured by Bloomberg Barclays US Corporate Index) to high yield (as measured by Bloomberg Barclays US Corporate High Yield Index) from the period Oct. 2004 - December 2019. The average return of those bonds’ subsequent 12-month return was compared to the Bloomberg Barclays US Corporate BB Index and is shown above.
Bottom line, while the party may have already started, it is by no means over. Come join the party!
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