Navigate Changing Markets with Fallen Angels

Despite a tough start to 2022, fallen angel bonds may provide a cushion during selloff, with diversified return drivers that support performance throughout the market cycle.

After outperforming in 14 out of the last 18 calendar years, the fallen angels¹ index (ICE US Fallen Angel High Yield 10% Constrained Index) had a rough start to 2022.² They underperformed the broad high yield index (ICE BofA US High Yield Index) by 2.53% (-7.04% vs -4.51%) in Q1 2022. Fallen angels’ higher duration accounted for the majority of underperformance this past quarter primarily due to rising rates, but also wider spreads. From a sector perspective, energy, consumer goods, telecom and autos were main detractors of performance with the energy sector detracting the most. These four sectors have on average 1.49x longer duration in fallen angels than the broad market, making them more vulnerable to higher rates.

The outlook for 2022, as mentioned before, was based on expectations for rising stars (bonds upgraded from high yield to investment grade) and the Fed. Both were indeed the larger themes in Q1. There was substantial rising star activity in the first three months of 2022:

• Kraft (KHC): upgraded from BB+ to BBB- with a positive outlook by S&P on March 11, stating that it had improved its operational execution, forecasting and hedging processes, divested businesses with higher commodity volatility and private label competition, and has managed its balance sheet conservatively. Moody's has a Baa3 rating on the credit and Fitch, a BB+, making its average rating investment grade. As a result, KHC became a rising star, removing $16.4bn from the fallen angel index. Kraft was originally downgraded back in February of 2020 and although it underperformed broad high yield over the last 6 and 12 months (due to the longer duration), it has outperformed broad high yield since entering the fallen angel index right before the pandemic.
• EQT Corporation: upgraded by Fitch from BB+ to BBB- on March 10 and then by S&P on March 28. Both credit agencies stated that EQT’s debt reduction efforts and strong cash flow generation were worth the upgrade. With investment grade ratings, EQT became a rising star at the end of this past month and removed $3.4bn from the index. Since entering the fallen angel index, EQT outperformed broad high yield by more than 30%. Current high energy prices could continue to benefit other companies in the energy sector as well.
• Earlier in January, Fitch upgraded Freeport-McMoRan (FCX) (removing $5.1bn), which was not on most, or any, of the sell side research lists of rising stars. FCX was a relatively old fallen angel, having entered the index in February of 2016 and, although it posted negative returns over the last 6 and 12 months, it managed to outperformed broad high yield since 2016.

Recent Rising Stars vs. Broad High Yield Index

As of 3/31/2022, returns greater than 1 year are not annualized.

Source: ICE Data Services, VanEck.

These upgrades provide continued support for our expectations in 2022. After a tough start to the year for bonds as interest rates have increased, investors may find a more attractive entry point to fallen angels. Fallen angels now yield 5.01 as of March 31, vs 3.42 at the beginning of the year (spreads, although wider, remain tight) and a shorter duration (6.14 vs 6.97 at the beginning of the year), with the removal of some large rising stars. A yield of 5.01 is just shy of the index 5Y average of 5.28 and a duration of 6.14 is slightly lower than its index 5Y average (6.38).

The Fed hiked interest rates by 25bps, as expected, but the story over the first three months of the year was focused on the yield curve; it inverted (by some measures), meaning that short-term bonds now yield more than long-term bonds. Usually when that happens, a recession follows, although this should be viewed within the current context of strong credit fundamentals. However there are clearly risks: COVID-19 remains, China is on lockdown, high inflation (US CPI was 7.9%), and a war (Russia and Ukraine) with global ramifications as these countries are suppliers of everything, from oil and gas to fertilizers. If a recession arises, higher quality bonds (fallen angels currently have 90% allocated to BB-rated issuers) could provide cushion in a selloff and, although credit migration may turn negative, fallen angels have historically benefitted from downgrade activity. In that regard, we believe fallen angels’ dynamic strategy, which benefits from multiple diversified sources of return, can help high yield investors navigate changing market conditions through a market cycle.

Fallen Angels Overall Stats

Yield-to-worst (YTW)³ for fallen angels and broad high yield increased throughout the first quarter as the 10-year treasury (10Y)⁴ moved from 1.52 to 2.38. Both saw their YTW hit the highest levels in mid-March (5.22 and 6.44), before falling to their current levels. Duration in the fallen angel space continues to shrink as long duration issuers (i.e. rising stars) exit the index, while duration on the broad high yield market expands.

Fallen Angels Index vs. Broad High Yield Index

Source: ICE Data Services, VanEck. ICE US Fallen Angel High Yield 10% Constrained Index (Fallen Angel) and ICE BofA US High Yield Index (Broad HY).

New Fallen Angels: Notably, there have been no fallen angels so far this year as the credit environment is still in decent condition.

New Rising Star: A total of three issuers were upgraded from HY to IG this year for 14.43% of the index being removed based on exit weights.

Issuers Upgraded to Investment Grade

Source: ICE Data Services, VanEck.

Fallen Angels Performance by Sector

With recent fallen angels, the energy sector as of the end of March hit its highest weight since the beginning of COVID-19. For March, the energy sector within the fallen angel index outperformed the broad high yield market (-0.14% vs -0.93%) despite posting negative returns as oil prices increased. The consumer goods sector dropped significantly after Kraft was upgraded and the index now has an allocation of less than 4%, which is lower than before the pandemic. Telecom is now the second largest weight; it had previously decreased when there were massive downgrades into high yield. Unfortunately, none of the 17 sectors posted positive returns for the first quarter of 2022.

Sector Performance of Fallen Angels

Source: ICE Data Services, VanEck. Define OAS %: difference between the yield of a bond with an embedded option and the yield on treasuries. YTD TR: Year-to-Date Total Return.

Fallen Angels Performance by Rating

The CC-rated bucket, which only has one issuer (Transocean) was the only to post positive returns for the first quarter of 2022. The BB-rated bucket saw a decrease in is weight from the ~95% to ~90% for the first time since May 2020, when it jumped from 82% to 92% when credit agencies downgraded multiple issuers due to COVID-19. Sell side shops expect for the remainder of 2022, and maybe into 2023, that slower growth and tighter monetary policy will fuel a rotation "up in quality" within high yield with BBs poised to outperform.

Fallen Angel Performance

Source: ICE Data Services, VanEck.

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