• ETF Insights

    Fallen Angels - From Sin to Win

    Martijn Rozemuller, CEO – Europe
     

    Fallen Angels: an expression going back to pre-Christian times, referring to angels expelled from heaven or having sinned1.

    Fixed income investors have been roaming the yield-deprived earth looking for returns; many hoping that COVID-19 state spending would push up interest rates. With euro sovereign yields, basically, at where we left off at the end of 2019, and with the U.S. Treasury having given up more than 100 basis points, investors may be frustrated. High yield bonds, however, form a notable exception. With spreads having spiked by 2.75%since the end of last year, it is an asset class worth considering for some. Whilst we acknowledge that it is not an asset class suitable for every investor; with central banks leading the way we believe that the emerging sub-category, “fallen angels” should be one to take seriously.

    What are fallen angels?

    Fallen angels are high yield corporate bonds, that at the time they were issued, were considered to be investment grade, but have since “sinned”, and therefore have been expelled from investment grade “heaven”; or rather in more financial terms, have been downgraded to sub-investment grade.

    A broad array of sectors is represented in the asset class, the largest currently being Energy, Banking and Automotive (figure 1).

    Figure 1 – Sector breakdown of ICE BofAML Global Fallen Angel High Yield Index

    Sector breakdown of ICE BofAML Global Fallen Angel High Yield Index

    Source: ICE, VanEck analysis. Data as of 31/5/2020. The breakdown is based on market values.

    Often, these bonds are issued by large corporations with well-known brand names, such as Ford, PemEx, Vodafone and Intesa Sanpaolo (figure 2).

    Figure 2 – Top 10 holdings of the VanEck Global Fallen Angel High Yield Bond UCITS ETF

    Top 10 holdings of the VanEck Global Fallen Angel High Yield Bond UCITS ETF

    Source: VanEck. Data as of 31/5/2020. These are not recommendations to buy or to sell any security. Securities and holdings may vary.

    To date, the outstanding nominal value of fallen angels amounts to USD 440 billion, constituting circa 20% of the global high yield volume (figure 3).

    Figure 3 – 20% of global high yield universe is made up of fallen angels

    20% of global high yield universe is made up of fallen angels

    Source: ICE, VanEck analysis. Data as of 31/5/2020.

    What makes fallen angels special?

    Historically, fallen angels have seen better risk adjusted returns than high yield bonds (figures 4 – 6).

    Figure 4 – Fallen angels have outperformed regular high yield bonds in the past

    Value of USD 100 initial investment

    Fallen angels have outperformed regular high yield bonds in the past

    Past performance is not a reliable indicator for future performance, this also holds for historical market return.
    Source: ICE, VanEck analysis. Data for the period 1/1/2005 - 30/4/2020. Fallen angels are represented by the ICE BofAML Global Fallen Angel High Yield Index, high yield by the of ICE BofAML Global High Yield Index

    Figure 5 – The outperformance holds for multiple time periods

    The outperformance holds for multiple time periods

    Past performance is not a reliable indicator for future performance, this also holds for historical market returns.
    Source: ICE, VanEck analysis. Data for the period 30/4/2010 to 30/04/2020. Fallen angels are represented by the ICE BofAML Global Fallen Angel High Yield Index, high yield by the ICE BofAML Global High Yield Index. The Sharpe ratio is based on the risk free 1-month USD LIBOR rate.

    Figure 6 – Credit quality of fallen angels compared to regular high yield bonds

    Index composition (composite credit rating)

    Credit quality of fallen angels compared to regular high yield bonds

    Source: ICE. Data as of 30/4/2020. Fallen angels are represented by the ICE BofAML Global Fallen Angel High Yield Index, high yield by the of ICE BofAML Global High Yield Index.

    Breaking down a market anomaly

    What can explain this historic outperformance? We see two reasons:

    • Timing effect: The market tends to anticipate downgrades. Many investment grade investors sold out before, either because of their dislike for the deteriorated risk profile, or simply because their mandate does not allow them to hold sub-investment grade bonds. As the high yield investor universe is significantly smaller than the investment grade universe, the weak technical position leads to overselling. Because rating agencies often lag the market, downgrades have historically coincided with the trough of the bond’s market price, on average. Once the actual downgrade has taken place, fallen angel investors step in, leading prices to revert to fair values.
    • Historically, fallen angels have had lower default rates, roughly equal recovery rates and higher upgrade propensities than high yield bonds. A potential reason is that many fallen angels have defensive mechanisms, such as their brand (example: KraftHeinz), tangible assets (example: Macy’s, which holds a sizeable real estate portfolio) or implicit state protection (example: Renault).

    Figure 7 – Fallen angels have better default and rating evolution characteristics

    Fallen angels have better default and rating evolution characteristics

    Historical performance is not a reliable indicator for future performance.
    Source: VanEck analysis, based on ICE data for the period 31/12/1999 to 30/4/2020. Fallen angels are represented by the ICE BofAML Global Fallen Angel High Yield Index, high yield by the of ICE BofAML Global High Yield Index.

    These elements are also reflected in a return decomposition. As can be seen in figure 8, for most periods the price return of high yield bonds is negative. I.e., their market price drops while they are in the index; conversely, the price return of fallen angels is positive.

    Figure 8 – Return decomposition of fallen angels versus regular high yield

    Return decomposition of fallen angels versus regular high yield

    Historical performance is not a reliable indicator for future performance, this also holds for historical market return.
    Source: VanEck analysis, based on ICE data. Fallen angels are represented by the ICE BofAML Global Fallen Angel High Yield Index, high hield by the ICE BofAML Global High Yield Index.

    The current uniqueness of fallen angels

    The current market climate has contributed to two factors that create a unique case for this asset class.

    Firstly, the available universe just increased by 50% compared to a year ago, while both yields and spreads have seen a significant uptake (figures 9 and 10). For example, in the U.S. there exists a positive correlation between the number of new fallen angels in a given year and the absolute returns of the index, as well as the returns relative to high yield (figure 11). Historically, the best years have been the ones during or immediately following large waves of fallen angels.

    Figure 9 – The number of fallen angels has increased dramatically since the start of the COVID-19 crisis

    Issues in the ICE BofA Global Fallen Angel High Yield Index

    Issues in the ICE BofA Global Fallen Angel High Yield Index

    Source: ICE.

    Figure 10 – Yields and spreads on fallen angels have spiked recently

    Yields and spreads on fallen angels have spiked recently

    Historical performance is not a reliable indicator for future performance, this also holds for historical market return.
    Source: VanEck analysis, based on ICE data. Data as of 31/5/2020. Fallen angels are represented by the ICE BofAML Global Fallen Angel High Yield Index.

    Figure 11 – U.S. fallen angel volume increase has corresponded with above average returns

    U.S. fallen angel volume increase has corresponded with above average returns

    Historical performance is not a reliable indicator for future performance, this also holds for historical market return.
    Source: VanEck analysis, based on ICE data. Data as of 30/4/2020. U.S. fallen angels are represented by the ICE US Fallen Angel High Yield 10% Constrained Index

    Secondly, the ECB announced it would extend its Pandemic Emergency Purchase Program (PEPP) with an additional EUR 600 billion, up from the already announced EUR 750 billion in March. As of this moment, bonds need to be investment grade in order to be eligible for the PEPP. In late April the ECB announced that fallen angels would also be eligible as collateral for banks to have access to the ECB’s liquidity facility. As a result, market participants are expecting fallen angels to also become eligible for the PEPP. The U.S. Federal Reserve (Fed) is leading by example: in early May it announced that it would begin buying fallen angels as part of its Secondary Market Corporate Credit purchase program.

    Central bank demand, combined with potentially improving economic forecasts, could provide further price support.

    How to invest in this asset class?

    Many investors may see high yield bonds as a natural candidate for an actively managed fund. However, SPIVA research shows that for the U.S., the majority of actively managed high yield bond funds have not outperformed their benchmarks (figure 12)3. As a result, a passive approach may be more suited.

    Figure 12 – The majority of actively managed high yield funds underperforms its benchmark

    U.S. actively managed high yield funds

    U.S. actively managed high yield funds

    Historical performance is not a reliable indicator for future performance.
    Source: SPIVA U.S. scorecord, year-end 2019. Data as of 31/12/2019

    For our investors we propose the VanEck Global Fallen Angel High Yield Bond UCITS ETF. The global scope of the fund enables an investor to benefit from economic cycle diversification, a larger number of potential issuers and currency diversification (figure 13).

    Figure 13 - Global fallen angels benefit from currency diversification

    Currency decomposition of the ICE BofA Global Fallen Angel High Yield Index, based on market values

    Global fallen angels benefit from currency diversification

    Source: VanEck analysis, data as of 30/4/2020.

    Most sin, even angels; therefore, by investing in them as they fall back to earth, one may benefit when they spread their wings and fly back up to the sky.

    1Source: Mehdi Azaiez, Gabriel Said Reynolds, Tommaso Tesei, Hamza M. Zafer The Qur’an Seminar Commentary /Le Qur’an Seminar: A Collaborative Study of 50 Qur’anic Passages, cited in Wikipedia.

    2Source: ICE, data as of 31/5/2020.

    3We use U.S. high yield bond funds as a proxy, because of data availability. In theory, the conclusion could be different for a global remit. However, we deem this unlikely, as 1) the U.S. is the largest region (37%) of the ICE BofAML Global Fallen Angel High Yield Index (as of 30/4/2020), 2) the underperformance of actively managed funds is very significant over longer time periods, 3) our own research of the largest global high yield funds indicates that most underperform over time.

    Fund-specific Disclosure

    VanEck Global Fallen Angel High Yield Bond UCITS ETF (the “Fund”) is a sub-fund of VanEck UCITS ETFs plc, an investment scheme which is registered in Ireland and subject to the European regulation of collective investment schemes under the UCITS Directive. The Fund is registered as UCITS fund and tracks a bond index. The value of an ETF’s assets may fluctuate widely as a result of its investment policy. If the underlying index falls in value, the ETF also falls in value.

    The Fund is not sponsored, endorsed, sold or promoted by ICE Data Indices, LLC (the Index Provider). The Index Provider has not passed on the legality or suitability of, or the accuracy or adequacy of descriptions and disclosures relating to the Fund, nor makes any representation or warranty, express or implied, to the owners of the Fund or any member of the public regarding the Fund or the advisability of investing in the Fund, particularly the ability of the ICE BofAML Global Fallen Angel High Yield Index (the “Index”) to track performance of any market or strategy. The Index is determined, composed and calculated by the Index Provider without regard to the Fund or its holders. The Index Provider has no obligation to take the needs of the holders of the Fund into consideration in determining, composing or calculating the Index. The Index Provider is not responsible for and has not participated in the determination of the timing of, prices of, or quantities of the Fund to be issued or in the determination or calculation of the equation by which the Fund is to be priced, sold, purchased, or redeemed. The Index Provider has no obligation or liability in connection with the administration, marketing, or trading of the Fund.

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