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    Yield Curve Moves Provide Another Tailwind for Fallen Angels

    Nicolas Fonseca, CFA, Associate PM
    July 19, 2021
     

    Fallen angel high yield bondshave continued to outperform broad high yieldin a variety of market conditions. In Q2 2021, fallen angels’ longer duration contributed to their 1.87% outperformance over the broad high yield bond market. The segment also benefitted from higher weights to recent fallen angels and going forward we expect credit ratings upgrades to increasingly contribute to outperformance.

    The yield curve flattened following the much-anticipated June Federal Reserve (Fed) meeting. Short-term rates rose while long-term yields declined due to the weaker outlook for longer-term growth, as investors expect the Fed to act quickly if inflation is not transitory. As we mentioned previously3, negative returns are not a given for fallen angel high yield bonds when rates rise. It hasn’t been the case so far this year, as the 10-Year Treasury rose by 81bps during Q1 2021, and both the fallen angel and the broad high yield indices posted positive returns (0.18% vs 0.90%, respectively) as of March 31, 2021.

    Q2 2021 was different. The 10Y barely moved – and actually fell to 1.45% on 6/30/2021 from 1.74% on 3/31/2021 – giving a boost to longer-term bonds. The fallen angel index has a higher duration than the broad high yield market, due to the general longer maturity of investment grade issuance. As a result, the flattening of the curvehas provided an advantage to fallen angels, which are now on top of the broad high yield market by 1.13% YTD as of 6/30/2021 and 1.87% in Q2 2021, after outperforming by 67bps in April, 3bps in May and 113bps in June. For Q2 2021, fallen angels returned 4.64% vs 2.77% for the broad high yield market and have returned 4.83% this year through 6/30/2021.

    Treasury Yield Curve Rates

    Treasury Yield Curve Rates

    Source: U.S. Treasury.
    The CMT yield values are read from the yield curve at fixed maturities, currently 1, 2, 3 and 6 months and 1, 2, 3, 5, 7, 10, 20, and 30 years. This method provides a yield for a 10 year maturity, for example, even if no outstanding security has exactly 10 years remaining to maturity.

    Fallen Angel Bonds vs. Broad High Yield and 10Y

    Fallen Angel Bonds vs. Broad High Yield and 10Y

    Source: ICE Data Services, US Treasury.

    Fallen Angel Unconstrained Approach

    The outperformance by fallen angels over broad high yield in Q2 2021came largely from the newer fallen angels5 that drove performance last year. The unconstrained sector approach of the fallen angel index provides differentiated exposure, particularly to the potential recovery of beaten down sectors. The higher allocation to energy (close to 30% since May 2020) is a clear example of this contrarian view—one that has been paying off as WTI crude oil has jumped from the high $40s at the beginning of the year to mid/lows $70s, helping energy companies improve their balance sheets.

    2021 Q2 Contribution to Outperformance (%) Avg Wgt Differential vs Broad HY (%)
    Total 1.87  
    Energy 1.37 15.09
    Consumer Goods 0.60 7.67
    Automotive 0.23 5.00
    Utility 0.22 3.61
    Banking 0.11 2.69

    Source: FactSet, VanEck

    The higher issuer allocation (capped at 10%) also added to performance. Among the top 10 contributors for Q2 2021, eight had entered during the wave of downgrades last year, including the three biggest fallen angels: Occidental Petroleum, Kraft Heinz and Ford.

    2021 Q2 Contribution to Outperformance (%) Date Index Entry Wgt At Index Entry (%) Wgt 6/30/21 (%)
    Total 1.87      
    Occidental Petroleum 0.76 Apr-20 10.00 10.00
    Kraft Heinz 0.60 Apr-20 10.00 8.96
    Ford 0.30 Apr-20 10.00 10.00
    APA Corp. 0.21 Jun-20 2.86 2.78
    FirstEnergy 0.19 Nov-20 3.98 4.25
    Western Midstream 0.17 Sep-20 3.83 3.57
    Ovintiv 0.13 Apr-20 1.56 1.73
    Telecom Italia 0.07 Nov-13 4.14 2.28
    EQT 0.07 Apr-20 2.83 1.86
    CF Industries 0.07 Oct-16 1.51 1.59

    Source: FactSet, VanEck

    Many of these issuers have discussed in recent calls their goals to return to investment grade.

    • Oxy’s Rob Peterson, Senior VP & CFO, during their 2021 Q1 call: “On past calls, I've highlighted our preference for a viable path to return to investment-grade credit rating…We are not there today, but we believe this goal is achievable”.
    • Ford’s John T. Lawler, CFO, during their Capital Markets Day: “Everything we have talked about today and are doing is built on disciplined capital allocation, making the right choices to create value for our customers and our investors…we are optimizing our capital structure with an objective to return to investment grade ratings”.
    • APA’s Steve Riney, Executive VP and CFO, during their 2021 Q1 call: ”You should understand, however, that our more relevant objective is to return to investment-grade credit status. To that end, we will continue to budget conservatively, focus on costs, free cash flow generation and debt reduction and maintain close contact with the rating agencies to ensure that we are taking the appropriate steps to achieve that goal in a timely manner”.
    • Western Midstream’s Michael P. Ure, President and CEO, during their 2021 Q1 call: “We maintain a very active dialog with rating agencies, meet with them on a very regular basis. We feel as if we're at investment grade, from a metric standpoint as we sit here today. And so our focus is on making sure that we can continue to maintain those overall metrics in totality. So that we're in an opportunity to be able to move out to the investment-grade credit rating scale…So for us, it's just about maintaining the metrics that we have today and if and when it comes and we welcome the chance to get back up to investment grade”.
    • Ovinitiv’s Corey Douglas Code, Executive VP & CFO, during their 2021 Q1 call: “Over the longer term, we will continue to steward our business to a leverage ratio of 1.5 times net debt-to-EBITDA or less at mid-cycle prices. We think this level of leverage is appropriate for an E&P company and consistent with an investment-grade credit rating. The credit rating agencies have taken notice of the strong outlook for our business and the acceleration of our debt reduction efforts. As such, we have recently received positive credit rating outlook changes from all of the rating agencies.”

    Some sell side shops have recently mentioned that the global economy recovering, higher corporate earnings and robust capital markets may help some of these issuers become rising stars in the coming months. JPMorgan estimates that there are approximately $57B dollars’ worth of BB-rated bonds that are one rating agency action away from regaining investment grade status.

    The chart below offers a quick reminder of how rising stars have historically performed relative to the broad high yield market.

    Fallen Angel Bonds Average Price Returns Prior to Credit Rating Upgrades

    Fallen Angel Bonds Average Price Returns Prior to Credit Rating Upgrades

    Source: ICE Data Services, VanEck. Data as of 6/30/2021.

    The yield to worst of fallen angels started the year at 3.80, rose to 3.91 at the end of Q1 but has been falling since then. Currently, the yield is 3.35. Duration for fallen angels has been relatively flat all year, barely moving from 6.82 at the beginning of the year to 6.81 at the end of the first half. Meanwhile, broad high yield has seen some extension by about 0.3 so far. Fallen angels’ longer duration contributed to their 1.87% outperformance vs. the broad high yield market as 60% of that figure came from yield curve movements.

      Fallen Angel Broad HY
      12/31/2020 3/31/2021 6/30/2021 12/31/2020 3/31/2021 6/30/2021
    Yield to Worst 3.80 3.91 3.35 4.24 4.27 3.86
    Mod. Dur to Worst 6.82 6.70 6.81 3.37 3.68 3.63
    Full Market Value ($mn) 252,730 233,333 233,701 1,543,269 1,554,247 1,640,768
    No. of Issues 328 308 295 2,030 2,049 2,110

    Source: ICE Data Services, VanEck

    New Fallen Angels

    Two fallen angel bonds joined the index in Q2, adding approximately $0.6B of debt for a total of $2.7B for the first half of 2021. We expect to see little to no activity on the downgrade cycle as multiple factors—such as the economy reopening, high vaccination rates, balance sheet repairs and low interest rates—have created a benign credit environment. High yield issuers have continued to take advantage of lower funding cost to refinance some of their existing debt. The ratings agencies are now expecting lower default rates thanks to positive market conditions and better economic outlook, translating into fewer downgrades overall.

    Month-end Addition Name Rating Sector Industry % Mkt Value Price
    May Proassurance Corp BB1 Financial Insurance 0.12 107.72
    June Verizon Florida Incorporated B1 Industrials Telecommunications 0.15 108.14

    Source: ICE Data Services, VanEck

    Rising Stars

    Just one rising star emerged in Q2. However, as mentioned, there are a number of potential candidates for upgrades to investment grade status. We expect more upgrades than downgrades going forward, as the COVID-19 dust settles and the economy keeps up its strong pace of growth. Owning some of the potential rising stars has historically provided outperformance as credit upgrades have followed a recovery in prices.

    Month-End Exit Name Rating Sector Industry % Mkt Value Price
    April MDC Holdings Inc. BB1 Basic Industry Building & Construction 0.41 122.88

    Source: ICE Data Services, VanEck

    Q2 2021 Performance by Sector

    There were no significant changes in the sector weightings for fallen angels throughout Q2. Energy keeps the top spot in terms of weight and returns for the quarter, but its price is on the lower end, potentially leaving more room to run, especially if crude oil keeps going up. Consumer Goods placed second behind energy (in terms of contribution to performance) as consumer demand has been high.

      Wgt (%) OAS Price Quarterly TR %
       12/31/2020   3/31/2021   6/30/2021   12/31/2020   3/31/2021   6/30/2021   12/31/2020   3/31/2021   6/30/2021   6/30/2021
    Automotive 10.00 10.00 10.00 274 232 186 106.31 106.21 108.83 3.52
    Banking 3.64 3.92 3.97 215 176 147 116.71 115.62 118.33 3.27
    Basic Industry 6.94 7.08 6.54 236 192 179 114.88 112.81 115.34 3.47
    Capital Goods 3.08 3.25 3.47 305 275 260 110.43 108.67 110.27 2.85
    Consumer Goods 12.38 12.64 11.75 221 160 147 114.82 112.78 118.83 5.66
    Energy 28.83 28.38 28.93 393 343 267 99.25 98.48 104.78 7.34
    Financial Services 0.92 0.95 1.01 263 216 196 124.95 120.02 125.50 5.80
    Healthcare 0.48 0.51 0.53 369 261 199 109.42 112.47 114.97 3.60
    Insurance 0.42 0.47 0.61 673 541 395 94.84 97.62 101.95 3.81
    Leisure 4.85 4.84 4.97 372 309 273 112.40 112.97 112.20 1.52
    Real Estate 3.77 4.05 3.73 511 452 318 96.45 96.39 101.41 3.40
    Retail 3.55 2.65 2.63 427 319 276 98.33 100.92 103.98 3.97
    Services 1.01 0.90 0.92 232 226 150 103.42 102.69 103.50 1.72
    Technology & Electronics 4.24 4.40 4.32 224 199 175 110.26 108.54 110.31 2.39
    Telecommunications 7.48 7.71 8.02 272 251 258 131.86 125.08 126.33 2.75
    Transportation 1.96 1.67 1.71 336 363 304 100.97 99.93 102.45 3.55
    Utility 6.45 6.58 6.87 207 200 180 111.11 107.44 110.06 3.56
    Total 100 100 100 313 267 225 107.67 106.58 110.57 4.64

    Source: ICE Data Services, VanEck

    Q2 2021 Performance by Rating

    Fallen angels continue to tilt heavily towards the highest ratings within high yield, with 94% being rated double-BB. Lower rated bonds performed the best over Q2 with CC-rated bonds returning almost 50% as investors keep searching for yield and have been willing to take additional risk to find it. With low default outlooks across the industry, being on the lower ratings may pay off, but it is important to note that the ICE BofA CCC & Lower US High Yield Index ended the quarter with an OASof 583, the lowest level in over a decade.

      Wgt (%) OAS Price Quarterly TR %
      12/31/2020 3/31/2021 6/30/2021 12/31/2020 3/31/2021 6/30/2021 12/31/2020 3/31/2021 6/30/2021 6/30/2021
    BB 94.56 94.02 93.91 296 246 214 108.81 107.53 111.25 4.52
    B 3.96 3.96 4.37 470 471 320 99.34 100.70 105.02 4.43
    CCC 1.14 1.60 1.41 639 539 479 91.66 95.76 99.70 6.16
    CC 0.15 0.21 0.32 2,254 1,604 1,043 33.99 46.59 68.13 49.60
    C 0.19 0.20   2,321 2,365   60.03 60.68   7.11
    Total 100 100 100 313 267 225 107.67 106.58 110.57 4.64

    Source: ICE Data Services, VanEck

    DISCLOSURES

    Fallen angel high yield bonds are represented by the ICE US Fallen Angel High Yield 10% Constrained Index (H0CF).

    Broad high yield (HY) is represented by the ICE BofAML US High Yield Index (H0A0), also referred as the broad benchmark.

    Source: VanEck

    Flattening the (yield) curve is when short-term and long-terms bonds are approaching the same see rates.

    FactSet. Contribution to outperformance represents the opportunity cost of an investment manager’s investment decisions relative to the overall benchmark. It is calculated by summing the three factors: allocation, security and interaction effects.

    OAS: The Option-adjusted spread is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to take into account an embedded option.

    VanEck assumes no liability for the content of any linked third-party site, and/or content hosted on external sites.

    A fallen angel bond is a bond that was initially given an investment-grade rating but has since been reduced to junk bond status.

    High yield bonds may be subject to greater risk of loss of income and principal and are likely to be more sensitive to adverse economic changes than higher rated securities.

    Please note that VanEck may offer investments products that invest in the asset class(es) included herein.

    This content is published in the United States for residents of specified countries. Investors are subject to securities and tax regulations within their applicable jurisdictions that are not addressed in this content. Nothing in this content should be considered a solicitation to buy or an offer to sell shares of any investment in any jurisdiction where the offer or solicitation would be unlawful under the securities laws of such jurisdiction, nor is it intended as investment, tax, financial, or legal advice. Investors should seek such professional advice for their particular situation and jurisdiction.

    The information herein represents the opinion of the author(s), but not necessarily those of VanEck, and these opinions may change at any time and from time to time. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. Any discussion of specific securities/financial instruments mentioned in the commentary is neither an offer to sell nor a recommendation to buy these securities. Historical performance is not indicative of future results. Current data may differ from data quoted. Any graphs shown herein are for illustrative purposes only.

    ICE BofAML US High Yield Index (H0A0, “Broad HY Index”), formerly known as BofA Merrill Lynch US High Yield Index prior to 10/23/2017, is comprised of below-investment grade corporate bonds (based on an average of various rating agencies) denominated in U.S. dollars.

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

    ICE BofA CCC & Lower US High Yield Index tracks the performance of U.S. dollar denominated corporate debt publicly issued in the U.S. domestic market with a given investment grade rating CCC or below.

    ICE Data Indices, LLC and its affiliates (“ICE Data”) indices and related information, the name "ICE Data", and related trademarks, are intellectual property licensed from ICE Data, and may not be copied, used, or distributed without ICE Data's prior written approval. The licensee's products have not been passed on as to their legality or suitability, and are not regulated, issued, endorsed, sold, guaranteed, or promoted by ICE Data. ICE Data MAKES NO WARRANTIES AND BEARS NO LIABILITY WITH RESPECT TO THE INDICES, ANY RELATED INFORMATION, ITS TRADEMARKS, OR THE PRODUCT(S) (INCLUDING WITHOUT LIMITATION, THEIR QUALITY, ACCURACY, SUITABILITY AND/OR COMPLETENESS).

    All investing is subject to risk, including the possible loss of the money you invest. Bonds and bond funds will decrease in value as interest rates rise. As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future results.

  • Authored by

    Nicolas Fonseca, CFA
    Associate PM

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