Should you catch the fallen angels?

Momentum investing buying 'hot' stocks or other assets that are shooting up in value is a popular investing strategy. This approach can lead to strong returns while the trend continues. However, it can also be very risky. Indeed, many momentum investors have found out the hard way that when sentiment turns they are then left with a portfolio of overvalued stocks that end up tumbling. As a result, some investors take the opposite approach. This involves buying 'fallen angels': bonds that have been downgraded to 'junk' by the rating agencies (see below), or shares that have experienced a large drop in value.

The logic behind this is that a decision to downgrade a bond, or a sharp fall in the share price, can lead other investors to overreact. In the case of bonds, this is partly because many major institutional investors (such as banks and insurance companies) and some bond funds aren't allowed to hold more than a certain number of riskier bonds. As a result, once a bond falls into junk territory they have to sell, even if the underlying risk profile of the firm hasn't changed that much.

This flood of forced sellers pushes down prices, creating an opportunity for savvy investors who are able to hold onto these downgraded bonds, or even take advantage of big institutions selling to buy some more. Between 2003 and 2015, the Bank of America Merrill Lynch Fallen Angel index delivered a total return of 199%, compared to 103.8% for the Morningstar High Yield Bond index (which covers high-yield debt in general).

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Of course, looking out for fallen angels and then creating a balanced portfolio of downgraded bonds is not straightforward for the ordinary investor. However, the Market Vectors Fallen Angel High Yield Corporate Bond ETF (NYSE: ANGL) offers one way to track this index.

There is also evidence of a similar effect in the stockmarket. Although the momentum effect means that stocks that have done well in the recent past are likely to continue doing so in the short term, the opposite applies over longer time periods. In other words, shares that have performed badly in the past will eventually do better than those that have done well.

A 1985 study by Werner De Bondt and Richard Thaler based on the US stockmarket found that portfolios of the worst-performing stocks over thepast 12 months tended eventually tobeat portfolios of the best stocks.Other studies, including a recent one by the brokerage firm Jefferies, also found that this 'buy the losers' strategy consistently ended up beating the market.

However, this research comes with several caveats. Firstly, the effect seems to be strongest when buying stocks in January (the end of the US tax year, when other people are selling poorly performing shares to generate tax losses). At other times of the year the effect is much weaker. It only worked if investors held the shares for at least a year: if you sell them earlier, there's a good chance they will underperform the market. There is also evidence that other factors, such as liquidity and the size of a firm, account for much of the difference in performance.

Another approach that is less likely to depend on these seasonal factors is to look at sectors and countries that have fallen dramatically to see if there are any individual stocks that are bargains. For example, after the bursting of the technology bubble in 2000-2003, and the banking crisis of 2008-2009, many people avoided all internet-related shares and financial institutions, irrespective of whether they were solid companies or not. This created buying opportunities for investors who kept their heads.

Understanding bond credit ratings

The latter name refers to the higher yield these riskier borrowers must offer to persuade investors to buy their debt, although it has become a bit of a misnomer in recent years: the yield on the Bank of America Merrill Lynch US High Yield index fell as low as 5.6% last year, compared to a 20-year average of 9.6% and a high during the financial crisis of 22.7%.

In theory, companies with investment-grade debt should be comfortably able to meet their obligations, while those that issue junk are much more precariously placed. And at theextremes of each scale the differences in default rates can be very substantial. Moody's estimates that between 1983 and 2010, investment-grade debt had an average one-year default rate of 0.09%, compared to a 4.75% rate for junk bonds.

However, the difference in default rates diminishes the closer you get to the investment/junk dividing line. During the same period, Baa3/BBB- debt had an annual default rate of 0.36%.By contrast, BB+/Ba1 debt had only a slightly higher rate of 0.67%. But the inability or unwillingness of many investors to hold sub-investment-grade bonds means that BB+ bonds (especially fallen angels) were priced for much higher defaults. Hence returns on BB-rated US corporate bonds were 1.3 percentage points per year better than returns on BBB debt between 1973 and 2009, according to Citigroup data.