Fallen angel fortunes rise again

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A raft of recent US investment grade bond downgrades amid waves of market volatility is creating a potentially ripe area of investment in so-called fallen angels, say Mellon head of fixed income efficient beta Paul Benson and senior portfolio manager Manuel Hayes.

Fallen angels are on the rise. These assets – essentially investment grade bonds downgraded to high yield – are attracting increasing attention from investors seeking the equity-like investment and bond-type risk many fallen angels appear to offer.

Over US$150bn of bonds have fallen from investment grade to speculative grade this year¹ against the backdrop of the unfolding Covid-19 coronavirus pandemic, wider market volatility and rising financial uncertainty. This growth of fallen angels may not be over yet. Mellon head of fixed income efficient beta Paul Benson believes there is also the potential for a further US$500bn downgrades from investment grade to high yield throughout 2020.

According to Benson, despite their credit downgrade, fallen angels can offer investors a potentially attractive prospect as they tend to hold comparatively strong ‘BB’ credit ratings, with about 85% classed as ‘BB’ grade investments. This, he believes, means they are intrinsically less likely to default than many other high yield assets and is just one reason why they should be considered an asset class in their own right.

Fallen angels are a higher quality subset of high yield. Typically, people don’t think of fallen angels as an asset class at all but we think it is time to start paying attention to this space, as its own unique asset class. We believe fallen angels present a significant investment opportunity in today’s environment given the equity-like return profile and bond-like risk profile they can exhibit,” he says.

Commenting on the events that have driven investment grade bond downgrades in 2020, Mellon senior portfolio manager Manuel Hayes says: “No one could have predicted the Covid-19 coronavirus pandemic would have been what tipped the balance for so many credit downgrades this year. At US150bn+ we have seen a truly historic amount of fallen angels created.

Looking forward we could potentially see another US$400-500bn of downgrades. This actually excites us for a lot of reasons. What we have seen year to date is more downgrades, more forced selling and more discounts which has ultimately led to higher returns and the prospect of more potential alpha for managers nimble enough to harness it.

According to Hayes, forced selling of investment grade bonds can create potential pockets of value, where supply-demand imbalances can mask the fair value of these bonds and where investment grade bonds can fall into the high yield universe at a significant discount. The value for investors, he adds, lies in identifying bonds that are under-priced relative to the broader high yield universe.

Despite recent market turmoil, Hayes says supportive action by the US Federal Reserve has also helped underpin market valuations, with the Fed launching specific support for fallen angels in May.²

During the March market turmoil the Fed came in and announced they were going to buy corporate debt, which was a very unusual move. A short while later it decided to extend this programme to buy, specifically, fallen angel bonds. This has provided a very supportive tailwind to the asset class in both secondary and primary markets,” he adds.

Some wonder if the latest surge in fallen angels – and the interest they have generated – is just a passing investment phase. But Benson believes the market can offer significant long term opportunity for committed investors.

We do think there is major potential out there right now but we don’t think this is just a temporary opportunity. Fallen angels do have asymmetrical return profile, where in ‘quiet’ years with few downgrades they tend to behave more like high yield assets.

However, in volatile markets you can see some significant outperformance of high yield assets by fallen angels. This is where markets find themselves now and we think the current trend will continue for some time and will also continue to present some attractive investment opportunities,” he concludes.

¹S&P Global statistics as at 15 May 2020.
²CNBC. The Fed is starting its program to purchase corporate bond ETFs. 12 May 2020.

GE0181 84590, 27 NOV 2020

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