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Aon Retirement and Investment Blog

Fallen Angels - Capitalizing Upon an Attractive Segment of the High Yield Market

It would be a mistake to think of the high yield universe as a single market. Many investors recognize that the risk and return characteristics of high yield can vary significantly by credit-quality, maturity, sector, size, and liquidity. However, these are not the only insightful ways to partition the high yield universe. As it turns out, a strong dichotomy exists between original issue high yield and fallen angels. Original issue high yield refers to bonds that were issued with a below-investment grade rating. High yield fallen angels are bonds that were investment grade at the time of issuance but have since been downgraded to below investment grade.
 
High yield fallen angels, across both U.S. dollar and Euro markets, have significantly outperformed original issue high yield (in both absolute and risk-adjusted terms) with fairly high consistency. Upon reflection, performance differentials between fallen angels and original issue high yield should not be too surprising, as fallen angels tend to have higher credit quality than original issue high yield, have longer maturities and duration (at least in the U.S.), higher convexity, tend not to be callable, have weaker covenants, and a different sector composition than original issue high yield. What is surprising is that the superior returns have been in excess of what could have been expected from these factors alone. The outperformance of fallen angels is not limited to a few industries, issuers, or time periods, but appears to be broad based. The natural question arises: Why have fallen angels outperformed original issue high yield? And more importantly, do the reasons for outperformance still hold true today?
 
We attribute the superior performance of fallen angels to both structural factors and human behavior, including: 

  1. Forced selling by various market participants;
  2. Overreaction and extrapolation of current events into the future;
  3. More attractive call features (fallen angels tend not to be callable), which can offer superior returns when spreads tighten;
  4. Issuers’ ability to access capital via the equity markets to repair balance sheets; and
  5. Management incentives to recapture investment grade status.
These factors are likely to remain in place going forward, which helps us draw several major conclusions from our research: 
  1. Fallen angels are an attractive segment of the high yield market and for certain investors may be considered as a significant component of a well-diversified portfolio.
  2. High yield investors should consider a strategic overweight to the fallen angel segment of the high yield universe.
  3. Investment grade investors should avoid constraints that lead to forced selling (to the extent possible).

The exhibits below demonstrate the impressive performance of U.S. dollar fallen angels over time.






Disclaimer & Sources for Indices Analyzed: Our research analyzed various Bank of America (BofA) Merrill Lynch bond indices, including the U.S. Fallen Angel High Yield Index (H0FA), the U.S. Original Issue High Yield Index (H0HY), the Euro Fallen Angel High Yield Index (HEFA), and the Euro Original Issue High Yield Index (HEHY). These indices are the source for charts numbered 1 through 4. The composite rating methodology that BofA employs is a simple average of ratings from the three agencies (Moody’s, S&P, and Fitch). A number is assigned to each credit rating, a simple average across agencies is calculated, and the resulting number is rounded to the nearest integer and mapped back to the corresponding rating. If only two agencies rate a bond, the composite rating is based on an average of the two. Likewise, if only one agency rates a bond, the composite rating is based on that one rating.

We believe the best way to access fallen angels is via a skilled active manager, though we have observed that product availability is fairly limited, and sometimes only available as a dedicated strategy (separate account). For investors without sufficient assets for a dedicated strategy, and are unable to overweight fallen angels via an active manager, we would recommend considering a modest allocation to a fallen angel ETF.

Fallen angels, as with high yield, is not suitable for all investors; fallen angels should be considered as part of a return-seeking allocation and not a substitute for risk-reducing high quality fixed income. Risks include the possibility that the historical benefits of fallen angels do not persist and that the overall market for high yield performs poorly.
 

Additional details on our research are available in our white paper, “Fallen Angels—Capitalizing Upon an Attractive Segment of the High Yield Market." A version for Canadian institutional investors is also available. 
 

Marc Coumeri is a Portfolio Manager for Aon Investment Solutions in Chicago.
 

The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs. Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal, tax or investment advice. Please consult with your independent professional for any such advice. The information contained within this blog is given as of the date indicated and does not intend to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information since the date of publication, or any obligation to update or provide amendments after the original publication date. The blog content is intended for professional investors only.


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