Tempted by Fallen Angels

As a swathe of the commodities sector is stripped of its investment-grade ratings a few gems will inevitably get caught in the fallout.

Readers of know that it usually pays to resist the temptations of fallen angels.

Readers of Paradise Lost know that it usually pays to resist the temptations of fallen angels.

Not so in the corporate credit world, where "fallen angels"-formerly investment grade-rated bonds that have been downgraded to non-investment grade ratings (Ba1/BB+ or below)-have tended to be the stand-out performers in the high-yield universe. Over the five years to the end of 2015 the Bank of America Merrill Lynch U.S. Fallen Angel High Yield Index outperformed broader high-yield indices by well over 2.5% annualised. Moreover, it did so with about nine-tenths of the volatility.

Fallen Angels Have Outperformed the Broader High Yield Market in the U.S.

Source: Bloomberg

These results are intuitive. Most fallen angels are bonds issued by good-quality, investment-grade companies going through some short-term difficulty. They often end up back in the investment-grade world, eventually. That accounts for the lower risk. In addition, by the time they come into high-yield indices most of the market response to the downgrade is already priced-in, as is the forced selling of investment-grade accounts, many of which are no longer mandated to hold the bonds. High-yield accounts get to pick them up disproportionately cheap, and that accounts for the higher return.

All of which makes recent action from rating agencies very interesting indeed.

Figures vary depending on which universe one looks at. Bank of America Merrill Lynch suggests that Q1 2016 was the second-biggest quarter on record for fallen angels.

Numbers from JPMorgan are even more striking: these suggest that the all-time high for the dollar-amount of bonds downgraded from investment-grade to high-yield in a single year came, unsurprisingly, in 2009, at $145bn globally. The total for 2015 fell just short of that at $143bn. In the first quarter of 2016 alone the total stands at $140bn. That makes 2016 the third-biggest year on record for fallen angels-with nine months still to go.

Q1 2016 Was the Third Biggest "Year" Ever For Fallen Angels

Source: JPMorgan

In anticipation of this Bank of America Merrill Lynch sent out a note to clients in January that looked at fallen-angel performance over recent years. It found that 60% of the current universe stabilized at BB+ and 88% kept within the BB band, with only 4% falling to CCC+ or below. The bank noted that many fallen angels immediately engage in deleveraging in a bid to recover their investment grade ratings. After widening for a good 12 months before the downgrade occurs, forced selling seems to contribute to an overshoot in pricing versus other BB-rated bonds as the transition takes place, but on average a rally is in motion 10 days later.

Some caution is warranted because the current wave of downgrades is distinctly sector-specific: 20 of the 26 new U.S. fallen angels downgraded in Q1 were issued by energy or metals-and-mining companies, which are also set to account for the vast majority of the defaults expected this year. The extent to which these bonds will stabilize hereafter depends somewhat on the trajectory of oil prices .

Nonetheless, the rally in high yield and energy since mid-February has already rewarded investors in fallen angels, with the Bank of America Merrill Lynch index of these bonds generating twice the return of the broader high-yield index over Q1.

Some energy sector names traded at 70-80c on the dollar in February-prices equivalent to other BB-rated names but not reflective of the fallen angels' better-quality fundamentals. We have enjoyed some gains from picking up Canadian energy-sector issues, for example.

Alongside our core late-stage credit cycle strategy of seeking out defensive value in sectors such as healthcare and gaming, we expect fallen angels to be a rich and attractive pocket of opportunity to add alpha through 2016.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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