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Navigate Changing Markets with Fallen Angels

April 25, 2022

Read Time 6 MIN

Despite a tough start to 2022, fallen angel bonds may provide a cushion during selloff, with diversified return drivers that support performance throughout the market cycle.

After outperforming in 14 out of the last 18 calendar years, the fallen angels1 index (ICE US Fallen Angel High Yield 10% Constrained Index) had a rough start to 2022.2 They underperformed the broad high yield index (ICE BofA US High Yield Index) by 2.53% (-7.04% vs -4.51%) in Q1 2022. Fallen angels’ higher duration accounted for the majority of underperformance this past quarter primarily due to rising rates, but also wider spreads. From a sector perspective, energy, consumer goods, telecom and autos were main detractors of performance with the energy sector detracting the most. These four sectors have on average 1.49x longer duration in fallen angels than the broad market, making them more vulnerable to higher rates.

The outlook for 2022, as mentioned before, was based on expectations for rising stars (bonds upgraded from high yield to investment grade) and the Fed. Both were indeed the larger themes in Q1. There was substantial rising star activity in the first three months of 2022:

  • Kraft (KHC): upgraded from BB+ to BBB- with a positive outlook by S&P on March 11, stating that it had improved its operational execution, forecasting and hedging processes, divested businesses with higher commodity volatility and private label competition, and has managed its balance sheet conservatively. Moody's has a Baa3 rating on the credit and Fitch, a BB+, making its average rating investment grade. As a result, KHC became a rising star, removing $16.4bn from the fallen angel index. Kraft was originally downgraded back in February of 2020 and although it underperformed broad high yield over the last 6 and 12 months (due to the longer duration), it has outperformed broad high yield since entering the fallen angel index right before the pandemic.
  • EQT Corporation: upgraded by Fitch from BB+ to BBB- on March 10 and then by S&P on March 28. Both credit agencies stated that EQT’s debt reduction efforts and strong cash flow generation were worth the upgrade. With investment grade ratings, EQT became a rising star at the end of this past month and removed $3.4bn from the index. Since entering the fallen angel index, EQT outperformed broad high yield by more than 30%. Current high energy prices could continue to benefit other companies in the energy sector as well.
  • Earlier in January, Fitch upgraded Freeport-McMoRan (FCX) (removing $5.1bn), which was not on most, or any, of the sell side research lists of rising stars. FCX was a relatively old fallen angel, having entered the index in February of 2016 and, although it posted negative returns over the last 6 and 12 months, it managed to outperformed broad high yield since 2016.

Recent Rising Stars vs. Broad High Yield Index

  Price Returns
  Last 6m Last 12m Fallen Angel Entry 2/29/2016
Broad HY -4.99% -4.51% 15.26%
Freeport-Mcmoran Inc -3.36% -2.81% 51.33%
  Last 6m Last 12m Fallen Angel Entry 2/29/2020
Broad HY -7.37% -6.85% -1.38%
Kraft Heinz Foods Company -12.20% -5.75% 4.46%
EQT Corporation -6.82% -5.37% 33.14%

As of 3/31/2022, returns greater than 1 year are not annualized.

Source: ICE Data Services, VanEck.

These upgrades provide continued support for our expectations in 2022. After a tough start to the year for bonds as interest rates have increased, investors may find a more attractive entry point to fallen angels. Fallen angels now yield 5.01 as of March 31, vs 3.42 at the beginning of the year (spreads, although wider, remain tight) and a shorter duration (6.14 vs 6.97 at the beginning of the year), with the removal of some large rising stars. A yield of 5.01 is just shy of the index 5Y average of 5.28 and a duration of 6.14 is slightly lower than its index 5Y average (6.38).

The Fed hiked interest rates by 25bps, as expected, but the story over the first three months of the year was focused on the yield curve; it inverted (by some measures), meaning that short-term bonds now yield more than long-term bonds. Usually when that happens, a recession follows, although this should be viewed within the current context of strong credit fundamentals. However there are clearly risks: COVID-19 remains, China is on lockdown, high inflation (US CPI was 7.9%), and a war (Russia and Ukraine) with global ramifications as these countries are suppliers of everything, from oil and gas to fertilizers. If a recession arises, higher quality bonds (fallen angels currently have 90% allocated to BB-rated issuers) could provide cushion in a selloff and, although credit migration may turn negative, fallen angels have historically benefitted from downgrade activity. In that regard, we believe fallen angels’ dynamic strategy, which benefits from multiple diversified sources of return, can help high yield investors navigate changing market conditions through a market cycle.

Fallen Angels Overall Stats

Yield-to-worst (YTW)3 for fallen angels and broad high yield increased throughout the first quarter as the 10-year treasury (10Y)4 moved from 1.52 to 2.38. Both saw their YTW hit the highest levels in mid-March (5.22 and 6.44), before falling to their current levels. Duration in the fallen angel space continues to shrink as long duration issuers (i.e. rising stars) exit the index, while duration on the broad high yield market expands.

Fallen Angels Index vs. Broad High Yield Index

  Fallen Angel Broad HY
  12/31/2021 3/31/2022 12/31/2021 3/31/2022
Yield to Worst 3.42 5.01 4.32 6.03
Effective Duration 6.97 6.14 4.04 4.18
Full Market Value ($mn) 196,932 142,481 1,610,169 1,461,914
No. of Issues 262 225 2,123 2,051

Source: ICE Data Services, VanEck. ICE US Fallen Angel High Yield 10% Constrained Index (Fallen Angel) and ICE BofA US High Yield Index (Broad HY).

New Fallen Angels: Notably, there have been no fallen angels so far this year as the credit environment is still in decent condition.

New Rising Star: A total of three issuers were upgraded from HY to IG this year for 14.43% of the index being removed based on exit weights.

Issuers Upgraded to Investment Grade

Month-end Exit Name Rating Sector Industry % Mkt Value Price
January Freeport-Mcmoran Inc BB1 Basic Industry Metals/Mining Excluding Steel 2.73 111.46
March EQT Corporation BB1 Energy Energy - Exploration & Production 2.00 105.82
March Kraft Heinz Foods Company BB1 Consumer Goods Food - Wholesale 9.70 106.50

Source: ICE Data Services, VanEck.

Fallen Angels Performance by Sector

With recent fallen angels, the energy sector as of the end of March hit its highest weight since the beginning of COVID-19. For March, the energy sector within the fallen angel index outperformed the broad high yield market (-0.14% vs -0.93%) despite posting negative returns as oil prices increased. The consumer goods sector dropped significantly after Kraft was upgraded and the index now has an allocation of less than 4%, which is lower than before the pandemic. Telecom is now the second largest weight; it had previously decreased when there were massive downgrades into high yield. Unfortunately, none of the 17 sectors posted positive returns for the first quarter of 2022.

Sector Performance of Fallen Angels

  Wgt (%) OAS Price YTD TR %
   12/31/2021   3/31/2022   12/31/2021   3/31/2022   12/31/2021   3/31/2022   3/31/2022 
Automotive 10.00 10.00 147 215 109.85 100.73 -7.58
Banking 4.07 5.38 125 200 114.90 105.96 -6.57
Basic Industry 4.25 1.45 173 243 112.44 99.68 -5.76
Capital Goods 4.12 5.45 225 259 110.72 102.45 -6.21
Consumer Goods 12.95 3.67 142 220 120.43 102.47 -11.41
Energy 28.04 30.47 240 260 106.42 98.06 -6.21
Financial Services 1.03 0.59 240 469 101.37 88.09 -7.44
Healthcare 1.98 2.37 180 218 106.51 98.95 -5.42
Insurance 0.46 0.63 283 272 104.28 99.90 -2.85
Leisure 3.76 4.76 269 288 105.75 100.73 -3.03
Real Estate 2.72 3.67 413 425 97.12 92.32 -3.71
Retail 4.78 5.96 270 284 101.96 94.63 -5.73
Services 0.39 0.54 87 132 103.86 101.09 -1.68
Technology & Electronics 3.44 3.83 176 216 109.25 101.87 -5.77
Telecommunications 9.11 11.71 283 340 121.24 108.57 -8.85
Transportation 1.66 2.22 221 259 104.18 97.06 -5.78
Utility 7.24 7.29 158 203 109.46 102.06 -6.27
Total 100 100 211 262 110.07 100.35 -7.04

Source: ICE Data Services, VanEck. Define OAS %: difference between the yield of a bond with an embedded option and the yield on treasuries. YTD TR: Year-to-Date Total Return.

Fallen Angels Performance by Rating

The CC-rated bucket, which only has one issuer (Transocean) was the only to post positive returns for the first quarter of 2022. The BB-rated bucket saw a decrease in is weight from the ~95% to ~90% for the first time since May 2020, when it jumped from 82% to 92% when credit agencies downgraded multiple issuers due to COVID-19. Sell side shops expect for the remainder of 2022, and maybe into 2023, that slower growth and tighter monetary policy will fuel a rotation "up in quality" within high yield with BBs poised to outperform.

Fallen Angel Performance

  Wgt (%) OAS Price YTD TR %
  12/31/2021  3/31/2022  12/31/2021  3/31/2022  12/31/2021  3/31/2022  3/31/2022
BB 94.49 90.11 200 244 110.70 101.22 -7.21
B 4.08 7.84 319 387 105.75 94.95 -5.81
CCC 1.13 1.51 425 478 102.99 94.78 -6.48
CC 0.31 0.54 1,346 962 55.99 68.92 25.42
Total 100 100 211 262 110.07 100.35 -7.04

Source: ICE Data Services, VanEck.

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DISCLOSURES

1 A fallen angel bond is a bond that was initially given an investment-grade rating but has since been reduced to junk bond status.

2 Source: FactSet. Represented by the ICE US Fallen Angel High Yield 10% Constrained Index (“Index”) and the ICE BofA US High Yield Index (“Broad HY Index”), respectively. Risk-adjusted returns are measured by Sharpe ratio, which is a statistical measure of the excess return of a portfolio over a risk-free rate of return (as found with a U.S. Treasury security) per unit of the portfolio's standard deviation of returns.

3 Yield to worst: lowest possible yield that can be received without defaulting.

4 10Y: 10 year treasury yield that the US government pays investors.

Please note that VanEck may offer investments products that invest in the asset class(es) or industries included in this blog.

Index returns are not Fund returns and do not reflect any management fees or brokerage expenses. Certain indices may take into account withholding taxes. Investors cannot invest directly in the Index.

A fallen angel bond is a bond that was initially given an investment-grade rating but has since been reduced to junk bond status.

High yield bonds may be subject to greater risk of loss of income and principal and are likely to be more sensitive to adverse economic changes than higher rated securities.

A rising star is a high yield bond that is upgraded to investment grade.

This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities/financial instruments mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. VanEck does not guarantee the accuracy of third party data. The information herein represents the opinion of the author(s), but not necessarily those of VanEck. ICE BofA US High Yield Index (H0A0, “Broad HY Index”), formerly known as BofA Merrill Lynch US High Yield Index prior to 10/23/2017, is comprised of below-investment grade corporate bonds (based on an average of various rating agencies) denominated in U.S. dollars.

ICE US Fallen Angel High Yield 10% Constrained Index (H0CF, Index) is a subset of the ICE BofA US High Yield Index and includes securities that were rated investment grade at time of issuance.

Fallen Angel U.S. High Yield index data on and prior to February 28, 2020 reflects that of the ICE BofA US Fallen Angel High Yield Index (H0FA). From February 28, 2020 forward, the Fallen Angel U.S. High Yield index data reflects that of the Fund's underlying index, the ICE US Fallen Angel High Yield 10% Constrained Index (H0CF). Fallen Angel U.S. High Yield index data history which includes periods prior to February 28, 2020 links H0FA and H0CF and is not intended for third party use.

ICE Data Indices, LLC and its affiliates (“ICE Data”) indices and related information, the name "ICE Data", and related trademarks, are intellectual property licensed from ICE Data, and may not be copied, used, or distributed without ICE Data's prior written approval. The licensee's products have not been passed on as to their legality or suitability, and are not regulated, issued, endorsed, sold, guaranteed, or promoted by ICE Data. ICE Data MAKES NO WARRANTIES AND BEARS NO LIABILITY WITH RESPECT TO THE INDICES, ANY RELATED INFORMATION, ITS TRADEMARKS, OR THE PRODUCT(S) (INCLUDING WITHOUT LIMITATION, THEIR QUALITY, ACCURACY, SUITABILITY AND/OR COMPLETENESS).

All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future results.

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