Catching fallen angels

The trade war has been a shock for the credit bond market. Fears of its inflationary implications sent government bond yields higher, while the negative implications for company earnings pushed spreads¹ up even further.

But European high yield credit investors are poised to benefit from these upheavals. On the one hand, policy confusion is likely to disproportionately hurt the US economy. On the other, where European issuers suffer downgrades, history suggests opportunities will open up for those positioned to take advantage of them.

Bond issuers suffering ratings cuts that take them from investment grade to high yield – known as fallen angels – have historically generated outsized returns for investors who buy right after the downgrade and then hold for a few months. If, as some economists fear, the tariffs trigger a global recession, angels will be falling like they haven’t done for years.

Fallen angels, celestial returns

Catching these fallen angels right after they suffer their drop in ratings delivers excess returns of 3.1 percentage points in the following year and 4.5 percentage points in the following two years relative to the peers² in the high yield index (see Fig. 1).³

That’s because in the lead-up of the downgrade, credit spread on these bonds widen dramatically. They tighten back equally precipitously afterwards.

Why this spike and reversal? Bonds with negative rating outlooks from the rating agencies usually trade at a cheaper price relative to their peers, therefore exhibiting a credit spread premium. However, fallen angels specifically exhibit a much larger premium at the time of the downgrade. This behaviour is chiefly related to the fact that investment grade investors are generally forbidden by their mandates to hold bonds with a junk rating (i.e. high yield), so they become forced sellers of fallen angels. Furthermore, the fact that the high yield market is much smaller than the investment grade market amplifies the selling pressure. The combination of these two effects results in an average excess credit spread premium of 120bps (see Fig. 2).

At the peak of the selling pressure, fallen angels represent very attractive investment opportunities and high yield investors will eventually take advantage of the discounted valuation by buying the bonds. As the smaller high yield market digests these newcomers, the spread of the fallen angels tightens and converges back to the level of their new peers, delivering a sizable outperformance to the bond holders. This process typically takes twelve months.  

Non omnes pares

Not all fallen angels are created equal. Three quarters of the fallen angels either outperform or perform in line to their high yield peers. But while identifying the best performers is important to maximise returns, investors can also boost their performance by avoiding the very worst fallen angels. The return profile of the bottom quartile is fat tailed, which is to say that steering clear of the worst 5-10% of fallen angels is sufficient to appreciably improve returns.

The investor's angle on angels

From an investment grade manager point of view, extending the holding period of a bond downgraded to high yield from the existing narrow window would allow for a more orderly selling in the market, resulting in less extreme valuations, and therefore reducing the cost of liquidating the position.

From a high yield investor point of view, although indiscriminate buying of fallen angels would result in an average excess performance, the prospect could be further improved by a more careful bond selection, avoiding the worst 5-10% of the fallen angel population. Here the focus should be on the corporate’s fundamentals, such as where its earnings and debt are trending and its quality of management.

It's an ill wind that blows no good, and even within recent market turmoil, there are opportunities to be found. That’s particularly true within credit, especially where angels fear to tread, which is to say in the ratings boundary between investment grade and high yield.