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Fallen Angel Watch: A Coming Wave of Downgrades?


WILLIAM SOKOL: After several years of strong returns in a relatively benign environment, how can high yield investors position their portfolios for a possible turn in the credit cycle? I'm Bill Sokol. I'm here today with Fran Rodilosso to talk about the high yield market and fallen angel investing. Fran thanks for being here.


FRANCIS RODILOSSO: Thank you, Bill.


SOKOL: Fran, if we are nearing a turn in the credit cycle, do you expect to see a wave of downgrades to junk status in the corporate credit market and should high yield investors be worried about that?


RODILOSSO: Yes, it seems likely we'll see a larger volume of fallen angels or bonds that were originally issued as investment grade that are downgraded to high yield, given where we are in the cycle. What's interesting about this credit cycle is the growth in credit, at least in the bond market, has largely been in the investment grade space, which is now a $6 trillion market in U.S. dollar terms. Half of that is in the BBB space, but only about $800 billion right now is BBB- rated and only about $120 billion of that $800 billion is on negative watch or outlook. And typically, in most years, even late credit cycle, you don't see that whole BBB- negative outlook, or negative-watch, paper fall to high yield.


That being said, this has been a very long credit cycle. We would expect to see higher volumes of fallen angels this year than we've seen in the past.


Two things to note. Number one, although we are late in the credit cycle and within the investment grade space we've seen a lower rate of issuance, more BBB issuance versus A issuance. The high yield market hasn't really grown (the high yield bond market) the last several years. So we don't believe the high yield bond market is going to be overwhelmed with more fallen angels than it can handle. That being said, large volumes of fallen angels have generally been very good for fallen angel investors or for the fallen angel portion of the high yield market.


If you look historically, the best return years, in absolute terms and relative to broad high yield for fallen angels have been since the index (ICE BofAML US Fallen Angel High Yield Index) was launched, the live index was launched in 2004. Each of the four periods of high fallen angel volumes have corresponded with the best years for fallen angel investors on absolute terms and relative to broad high yield.


SOKOL: And what's been the driver of that outperformance of fallen angels versus the broad high yield market?


RODILOSSO: There're really three drivers of return. The bonds tend to come in at discounts to par. In fact, they tend to lose on average 7% or 8% of their value in the six months before entering the fallen angel index. Basically fallen angels are a lagging indicator of the credit cycle and a lot of the damage in those bonds tends to be done by virtue of force selling by investment grade investors before the bonds enter fallen angel indexes. So that technical aspect, basically buying the news, being a contrarian investor, has worked very well for fallen angels and that's been the largest single driver for fallen angel outperformance.


But also the way fallen angels tend to lag the credit cycle, the sector orientation within the fallen angel index versus a broad high yield index can be quite different. And, historically, fallen angels have been underweight certain sectors as they've fallen and then become overweight sort of after the cycle’s ended or hit bottom for those sectors. That's happened in energy and financials and automotives, in mining at various periods over the last 12 years.


A third reason for long-term fallen angel outperformance has actually been a higher overall credit quality. The fallen angel index tends to have a much higher BB component, although some fallen angels do keep going to B or CC, and that credit quality aspect has helped in periods of spread widening, 2018 notwithstanding.


SOKOL: Thanks, Fran, for sharing your insights today.


RODILOSSO: My pleasure Bill.


SOKOL: And if you'd like to learn more about fallen angel investing or subscribe to receive additional insights from Fran and other VanEck thought leaders, please visit our website at www.vaneck.com.



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