The global high yield bond universe will likely witness an influx of “fallen angels” in 2016, according to our market analysis. Fallen angels are issues whose credit ratings have been cut from investment grade (BBB- or higher) to high yield (BB+ and below). While this trend may appear troubling to investment grade managers, for investors targeting high yield, it isn’t necessarily a bad thing. Fallen angels are often higher quality than the average high yield company and may have a better chance of returning to investment grade: Hence an influx of these companies could boost the long-term return potential of the overall high yield sector.
In the European high yield universe, for example, fallen angels have outperformed original high yield issues (i.e., those that were always rated high yield) by more than 3% over the past 10 years, based on excess return over swaps. And on a calendar year basis, European fallen angels have outperformed original high yield issues in 10 of the last 14 years (all data according to Bank of America Merrill Lynch as of 31 December 2015).
There are several reasons fallen angels historically outperformed original high yield issues:
- Lower probability of downgrade: Having been downgraded to non-investment-grade, fallen angel ratings tend to be stable thereafter. For example, as of 31 December 2015, 88% of all European fallen angels are rated in the BB category, with only 4% seeing their rating fall to CCC+ and below.
- Higher probability of upgrade: Just as fallen angels see fewer downgrades, they also tend to have a higher probability of being upgraded in the future, often due to management embarking on significant deleveraging measures.
- Prices tend to fall before a downgrade: As a company’s fundamental prospects diminish, its bonds sell off in expectation of future downgrades. This means that by the time a fallen angel enters the high yield index, the downgrade has often been priced in already.
- Prices often rise after a downgrade: As prices often fall before, they also often rise after. This is partly due to technical factors – many high yield investors start buying the bonds to reduce their tracking error to the index – but also due to fundamentals. Fallen angels tend to be larger-than-average companies that have more options to maintain or improve their ratings from asset disposals or equity raise-ups versus smaller original high yield companies.
Based on our research, we expect a higher-than-average volume in fallen angel bonds globally this year. In Europe, we think they could swell the high yield market by 10%–12% and offer attractive investment opportunities as the downgraded issuers will likely be more diversified across sectors than in the U.S., where we expect the majority of downgrades to come from the commodities sector.
That said, while fallen angels have historically outperformed, we shouldn’t assume they always will or that they come without risk, because they do. In 2010 and 2011, for example, they underperformed due to subordinated bank debt and peripheral eurozone bonds. Identifying the strongest of the fallen angels was critical during this time. While an influx of fallen angel supply has the potential to boost long-term returns, fundamental research, including deep sector expertise, will always be critical in identifying the best of these firms to avoid unnecessary risk and make the most of the opportunity.