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High Yield: Why Fallen Angels Stir Our Spirits

Fallen angels are multiplying exponentially. The best time to buy such bonds at attractive levels, in our view, is just before they get downgraded, since some high yield managers can’t buy investment grade.

We believe investors can potentially generate equity-like returns in certain fallen angel or potential fallen angel bonds, with less risk than equities. While current valuations remain attractive, Exhibit 1 shows that fallen angels have shown significant outperformance over long (and shorter) periods of time. 

As cited below, income return is a proxy for a high yield bond’s coupon. Fallen angels have a lower income return versus originally issued yield. But the price return is actually positive versus originally issued high yield that is coupon-minus. While most high yield managers over the years have focused on yield by regularly clipping coupons and truncating that downside, they were less concerned with total return. But yield is only part of the picture. Total return potential tells the entire story.

Exhibit 1. Focus on Total Return

Image - Chart 1 - High Yield: Why Fallen Angels Stir Our Spirits

Source: JPMorgan as of 4/14/20

A Much Bigger Pond to Fish In

Through the first five months of 2020, the volume of fallen angels, bonds that descended from investment grade to high yield, was more than 10 times higher than all of 2019. (See Exhibit 2.)

Exhibit 2: Fallen Angel Volume Forecast to Exceed 2009 Levels

Image - Chart 2 - Why Fallen Angels Lift Our Spirits

Source: JPMorgan as of 4/14/20

Historical Performance is Encouraging

The sheer growth of fallen angels spells considerable potential opportunities for nimble managers with rigorous research that can spot relative values and manage risk. While past performance is no guarantee of future results, consider the historical results of fallen angels shown in Exhibits 3 and 4. According to Seix analytics, fallen angels one-year annualized rolling returns outperformed 75% of the time. Three-year annualized rolling returns outperformed 94% of the time.

Exhibit 3 - Fallen Angels Outperformed 75% of the Time1

Image - Chart 3 - Why Fallen Angels Lift Our Spirits

Exhibit 4 - Fallen Angels Outperformed 94% of the Time2

Image - Chart 4 - Why Fallen Angels Lift Our Spirits

1 Since inception of the Fallen Angel Index (H0CF) 12/31/96, using monthly rolling 1-year periods.
2 Using monthly rolling 3-year periods.
Past performance is not indicative of future results.
Source: Seix analytics; Fallen Angels – ICE US Fallen Angel High Yield 10% Constrained Index (H0CF); Original issue HY – ICE BofA Original Issue High Yield Index (H0HY): Broad High Yield – ICE BofA US High Yield Index (H0A0). As of 4/30/20.

Timing Matters

Since the investment grade market tends to “shoot first and ask question later,” increasing volumes of investment grade downgrades tend to benefit high yield managers as illustrated in Exhibit 5. This shows that the best time to invest in fallen angels is when a lot of fallen angels are coming into the market. The first quartile depicts when the greatest amount of fallen angels were coming in. The fourth quartile shows when there were no fallen angels coming into high yield. 

Exhibit 5. The Best Time to Invest in Fallen Angels is When Downgrades Are High

Image - Chart 5 - Why Fallen Angels Lift Our Spirits

Note: Quartiles categorized based on monthly total par dollarvolume of bonds downgraded to fallen angels, with 1st quartile having the highest dollar amount and the 4th quartile with the lowest dollar amount.
Past performance is not indicative of future results.
Source: Seix analytics; Fallen Angels – ICE US Fallen Angel High Yield 10% Constrained Index (H0CF) as of 4/30/20.

Conclusion

We’ve been waiting for a massive influx of fallen angels for some time. Now that this trend is in place, it has transformed the high yield asset class—in a positive way, in our view. We expect to see fallen angels overshadow gross new issuance of BBBs for the foreseeable future. While that probably won’t be a long-term dynamic, it should be a great potential opportunity for active managers with the agility to identify and exploit relative value opportunities. Fallen angels tend to have big market caps and large asset bases. That means they have a lot of levers to raise liquidity or to raise cash to pay down debt to get them through cyclical issues. Once they work through those issues and return to some level of normalcy, we would expect to see spreads snap back in and drive total returns.

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Important Risk Considerations
Credit & Interest: Debt securities are subject to various risks, the most prominent of which are credit and interest rate risk. The issuer of a debt security may fail to make interest and/or principal payments. Values of debt securities may rise or fall in response to changes in interest rates, and this risk may be enhanced with longer-term maturities. High Yield-High Risk Fixed Income Securities: There is a greater level of credit risk and price volatility involved with high yield securities than investment grade securities. Foreign Investing: Investing internationally involves additional risks such as currency, political, accounting, economic, and market risk. Industry/Sector Concentration: A fund that focuses its investments in a particular industry or sector will be more sensitive to conditions that affect that industry or sector than a non-concentrated fund. Market Volatility: Local, regional, or global events such as war, acts of terrorism, the spread of infectious illness or other public health issue, recessions, or other events could have a significant impact on the fund and its investments, including hampering the ability of the fund’s portfolio manager(s) to invest the fund’s assets as intended. Prospectus: For additional information on risks, please see a fund’s prospectus.

The J.P. Morgan U.S. High Yield Index is designed to mirror the investable universe of the U.S. dollar domestic high yield corporate debt market. The index is unmanaged, its returns do not reflect any fees, expenses, or sales charges, and it is not available for direct investment.

ICE US Fallen Angel High Yield 10% Constrained Index (H0CF) is a subset of The ICE BofA US High Yield Index (H0A0), including securities that were rated investment grade at time of issuance.

ICE BofA US Original Issue High Yield Index (H0HY) is a subset of the ICE BofA US High Yield Index, including securities that were not rated investment grade at the time of issuance.

ICE BofA US High Yield Master II Index (H0A0) is a commonly used benchmark index for high-yield corporate bonds. It is administered by Merrill Lynch. The Master II is a measure of the broad high yield market, unlike the Merrill Lynch BB/B Index, which excludes lower-rated securities.

A Basis Point (bp) is equal to 0.01%.

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