What are “fallen angels” – and why have they been such good investments?
In the first of a series of articles on different aspects of investing in bonds, David explains what “fallen angels” – and what purpose they serve in a portfolio.
In the jargon-filled world of Wall Street and the City, few financial terms are quite as evocative as the phrase, “fallen angels”.
So what does it mean, and why might an investor want to invest in a fallen angel?
When high-flying companies take a tumble
If we use credit ratings as a measure of risk, then sitting at the top of the fixed-income (bond) market hierarchy are those entities – businesses or governments – that have an investment-grade rating. This is the highest available, meaning that they are regarded as very low risk.
“Fallen angels” are companies which have been downgraded from investment grade to sub-investment grade. In short, they were once viewed as low risk by the credit ratings agencies, but have now fallen on harder times.
Their numbers include some of the best-known names in the corporate world – Ford, Kraft Heinz, Renault and Marks & Spencer are just a few of the issuers that have become “fallen angels” so far this year.
Why do these downgraded bonds attract such interest? Some of it is pure schadenfreude at seeing a once high-flying brand take a tumble. But there’s a harder-edged rationale too – many bond fund managers focus on these investment-grade dropouts because they believe that the market has been overly judgemental. In simple terms, fallen angels can present good investment opportunities.
To understand why fallen angels can be so lucrative as an investment, you need to understand that categories matter a lot to bond investors. Everything has its place, and everything is judged on risk.
Investment grade (IG) bonds and high-yield (HY) bonds are typically treated as entirely different silos in bond portfolios. So if a bond moves from one category to another following a downgrade, it’s not unreasonable to expect a sudden burst of trading activity as some institutions become forced sellers.
Here’s a hypothetical example. A globally recognised company might boast a very high grade rating – say Aa3 (using Moody’s) or AA- (for S&P and Fitch). But then its profit margins start to deteriorate, and it starts to pile on debt. As a result, it finds itself downgraded at first to single A status, and then to the much riskier BBB (or Baa, using Moody’s) category.
Once a bond issuer has a BBB rating, the next downgrade is to BB or even single B (or Ba and B using the Moody’s system) ie, non-investment grade. That move takes it out of the most liquid bit of the bond market into a less liquid segment regarded as much riskier – high yield or “junk”, as it’s called.
A key point here is that many large institutions, such as pension funds, have strict investment criteria which specify just how many junk bonds they can hold – in some cases, none at all.
A downgrade to high-yield status also results in those bonds being kicked out of any index that only invests in investment-grade bonds, forcing tracker funds and exchange-traded funds (ETFs) to divest them too.
Thus, a downgrade from investment grade to high yield will almost automatically trigger a wave of forced selling.
The state of play in today’s junk bond market
Such downgrades happen with alarming regularity. Ratings agency S&P, for instance, in the year to April 17th, had already taken negative rating actions on 383 investment-grade rated issuers affected by Covid-19 and the oil price slump. Meanwhile it had also “junked” 23 issuers, sending them sliding from BBB- to BB+.
By the start of September, that figure had risen to 34, making 2020 the third-highest annual total ever (the highest came in 2009 in the wake of the financial crisis, with 57 fallen angels in total).
Meanwhile, in terms of total value, 2020 is on course to be a record-breaker: it looks like a we’ll see a total of $640bn in global fallen angel debt this year. The previous record was $487.86bn in 2005.
The coronavirus and ensuing lockdown is mostly (though not wholly) responsible for the downgrades seen thus far. Not only has coronavirus hammered corporate creditworthiness, it has also seen companies race to raise cash to tide them over through tough times.
However, while such a huge wave of fallen angels might have been expected to cause serious turbulence in bond markets, central banks have stepped in to underwrite the market. At the start of the current crisis, the Federal Reserve, for the first time ever, declared that it would be able to buy fallen angels, provided that they had recently held investment-grade ratings.
As a result, noted Nick Kraemer of S&P in September, “thus far the speculative-grade bond market appears to have comfortably absorbed debt that was recently downgraded from triple-B”.
Why would anyone invest in a fallen angel?
So where’s the appeal? Well, after a downgrade, as the selling intensifies, it’s quite possible for the price of these bonds to fall more sharply than is deserved. The difference between BBB- and BB+, in balance sheet terms, may be quite incremental. It’s the forced selling of the bonds that can push them into “cheap” territory, especially as many fallen angels tend to be market leaders.
The trick for smart bond fund managers is to spot the fallen angels that have been oversold and still boast a decent business model – and balance sheets that can be repaired over time with careful hard work.
If such a business survives and restructures, the recovery might even result in the original downgrade being reversed, as the business re-acquires an investment grade rating. That’s a strategy that can pay off.
A recent analysis of returns since 1997 (through to 2020) found that global fallen angels have produced an annualised return of 9.11% compared to 5.3% for global original issue high-yield bonds; 5.3% for global investment grade; and 6% for all global high yield bonds.
That said, those superior returns have also come with much higher volatility, which is another way of saying that not all fallen angels are a good investment. Indeed, fallen angels are actually more likely to default than those bonds originally classed as high yield when first issued.
Sometimes a once well-known name turns into a fraud (Enron), or is pushed into decline by structural market changes (retail property jumps to mind). But of the fallen angels that survive the first downgrade, most have a high chance of regaining an investment grade rating after a period of balance sheet restructuring.
The moral of the story? Investing in cheap fallen angels can pay off – but only if you stick to those with a chance of redemption!