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Fallen Angel Bonds Performance Drivers

FRAN RODILOSSO: There are several key drivers of fallen angels' outperformance. First and most significantly, when bonds cross-over from investment grade to high yield, there's naturally a change in ownership from investment grade-based investment portfolios to high yield and more opportunistic investors. But during that period, that cross-over from BBB to BB, there tends to be a lot of forced selling. In fact, overselling.

In the six months prior to a bond being downgraded from investment grade to high yield in fact, historically, they've lost 7-8% in price terms. The hypothesis that it’s actually overselling has been proven historically, at least so far, as, on average, those bonds have recovered most of that price loss in the six months post downgrade. So, that pricing anomaly is the most important aspect of a fallen angel index in terms of its performance versus a broad high yield index. But there are two others.

One is sector differentiation. In simple terms, a fallen angel index is not adding bonds at the top of a cycle when there's a lot of new issuance in the sector. It tends to add bonds after cycles bottomed out, when there are a lot of downgrades. It's contrarian, but that also leads to very different sector exposures. That also historically has worked in favor of fallen angel indexes.

Finally, quality. The majority of fallen angels stay in the BB category. In recent years 70-80% of a broad fallen angel index has stayed in the BB category versus, on average, a little less than 50% in the broad high yield market, and that has provided some downside protection when spreads move wider.

Yield Comparison to Broad High Yield Market

Because fallen angels were originally issued as investment grade, there tends to be longer maturities. That is part of why fallen angels often remain in the BB category. They've longer debt profiles, more financial flexibility. That also does mean though, they'll have a longer duration, on average, than broad high yield, and historically that duration difference has been about one to two years. Also, because of the higher quality, fallen angels have tended to have a lower yield than the broad high yield market. Though recently, that yield gap has been very narrow relative to its historical levels.

Role of Fallen Angel Bonds Within a Portfolio

We've seen investors use fallen angels in a variety of ways in a portfolio as either a complement or substitute, versus active or passive high yield alternatives. We think the most common use has probably been more as a complement, adding more fallen angels with a different risk/return profile than broad high yield to a portfolio that may actually contain some active and passive options. But on an absolute basis and risk-adjusted basis, fallen angels warrant use in a variety of ways, including as a substitute for active.

This late in the credit cycle, investors, in considering their positioning in high yield, if they're tactical in terms of their high yield allocations, they may be looking to stay away or wait ‘til the cycle turns. Giving current central bank policy, growth outlook, even amid declining earnings, the credit cycle could last for quite a while still, and high yield still offers attractive yields versus a lot of other asset classes, even considering the risks.

The Turning of the Credit Cycle

So, the way I look at fallen angels though is, a good alternative through the credit cycle. The high BB component can offer some downside protection when spreads start widening again. The differentiated sector exposure may or may not help, but historically has helped in terms of which sectors have performed worse when the credit cycle turned hardest.

But also, because fallen angel indexes tend to be very dynamic as the credit cycle turns, especially as it bottoms out and adds a lot of those credits in the underperforming sectors, a lot of formerly BBBs, that are now BBs that have lost significant value, has tended to snap back faster than the broad high yield market. So, we think fallen angels are an interesting way to play high yield through the cycle. Historically, that's been true.