What are Fallen Angel Bonds?
TOM BUTCHER: Can you tell me about fallen angel bonds and the investment opportunities that they may offer?
FRAN RODILOSSO: Let's start with the technical definition. A fallen angel refers to a bond, not necessarily an issuer or a company. Fallen angel bonds were issued originally as investment grade bonds. Subsequently, they've been downgraded to sub-investment grade by ratings agency standards: BB+ or lower. Fallen angel bonds tend to be issued by companies that might be better known than some of the original issue high yield borrowers in the market. A few examples of companies whose bonds are fallen angels today include: Sprint, ArcelorMittal, Nokia, JC Penny, etc. 1
In terms of the opportunity fallen angel bonds represent, consider what happens when an issuer's bonds are downgraded. Typically, it means that the business is suffering in some way, shape, or form, either from a balance sheet perspective or perhaps from a loss of revenue or market share that's causing some stress on the company’s ability to pay its debt. The bonds typically fall from BBB to BB, but some of these companies have a well-known brand and possibly a larger equity market capitalization than an original issue high yield borrower. On average, fallen angel bonds tend to have a much higher equity capitalization and in many cases, because of the nature of their business, their long history, their brand, and also the way their debt was originally structured, their investment grade debt tends to be much longer in maturity. Fallen angel borrowers may have greater flexibility to re-strengthen their balance sheets. They may have valuable assets that have market value. They may have longer time-to-maturity for a good part of their debt and a greater ability to navigate around that. They also tend to have a higher incentive to regain their investment grade status than many original issue high yield borrowers. They're not necessarily high-growth companies that expect a high cost of capital. They count on that low cost of capital that investment grade status brings and they are highly motivated to return to it.
BUTCHER: How big is this market and what is its average credit quality relative to the broader market?
RODILOSSO: Fallen angels represent about 12% of the broad high yield market in terms of size, with about $150-$200 billion outstanding today. That can change over time depending upon the credit cycle. In terms of credit quality, as per the ratings agencies, the fallen angel universe tends to have a much higher percentage of BB-rated credits. At the end of 2015, over 80% were rated BB- or higher on average by the credit ratings agencies, versus about 48% in the broad high yield market.
It's important to note that the opportunity that fallen angels or any credit story represent comes with risk. Not all fallen angels stay in that BB category. As I said, over 80% are rated BB- or higher, which is more than in the broad high yield market, but some fallen angel bonds do continue to descend to B. Additionally, there are some defaults in the fallen angel universe. However, over the twelve years of history during which an index has tracked this universe, fallen angels have outperformed the broader high yield market . They've also had a lower default rate and a higher propensity to re-ascend to investment grade. It’s those areas that based on history suggest an opportunity in fallen angels.
BUTCHER: Can you tell me about the performance of fallen angel bonds?
RODILOSSO: Yes. The fallen angel index (The BofA Merrill Lynch US Fallen Angel High Yield Index) that has been around for a dozen calendar years has now outperformed the broader high yield market nine out of those twelve years. While that's obviously not a forward-looking statement, it does suggest that some fallen angel characteristics have proven to lead to some impressive returns relative to the broader high yield market.
BUTCHER: How would you characterize investing in fallen angel bonds?
RODILOSSO: Buying fallen angel bonds or investing in a fallen angel-type product is really two things. Again, it's gaining access to the sub-investment grade bond universe, i.e., buying high yield bonds. As we discussed, however, it's buying the higher credit quality portion of the high yield universe, traditionally that much higher BB component. Additionally, the whole dynamic of fallen angels being bonds of issuers that have been downgraded or experienced a series of downgrades tends to mean the bonds have in general lost a decent bit of value by the time they become fallen angels. In a way, fallen angel investing is a contrarian strategy. You're buying bonds that have crossed over from investment grade to high yield and that have seen a lot more selling than buying in the months leading up to the crossover.
BUTCHER: And Van Eck has a fallen angel bond ETF?
RODILOSSO: That's correct. One way to access the fallen angel universe in a pure way is through ANGL, which is Van Eck's fallen angel ETF.
BUTCHER: Thank you very much.
RODILOSSO: My pleasure.
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1As of January 31, 2016, Market Vectors Fallen Angel High Yield Bond ETF net assets included 6.5% in ArcelorMittal, 0.8% in JC Penney, 3.4% in Sprint, and 1.1% in Nokia.
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BofA Merrill Lynch U.S. High Yield II Index (H0A0) is comprised of below-investment grade corporate bonds (based on an average of Moody’s, S&P and Fitch) denominated in U.S. dollars. The country of risk of qualifying issuers must be an FX-G10 member, a Western European nation, or a territory of the US or a Western European nation.
BofA Merrill Lynch US Fallen Angel High Yield Index (H0FA), a subset of H0A0, is comprised of below- investment grade corporate bonds denominated in U.S. dollars that were rated investment grade at the time of issuance.
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