Fran Rodilosso (FR): Fallen angel bonds, a subset of the high-yield bond universe that were rated investment grade at the time of their issuance, have historically outperformed original issue high-yield bonds, as measured by the BofA Merrill Lynch U.S. Fallen Angel High Yield Index (H0FA) and BofA Merrill Lynch U.S. High Yield Master II Index (H0A0), respectively.
In trying to understand why fallen angels have outperformed, we thought that some of the possible reasons were compelling. Fallen angels, having been investment grade, tend to be bonds issued by larger, more established companies. The capital structure of these companies, even though they tend to be in a credit ratings decline, might still allow greater flexibility than is the case with original issue high-yield borrowers. They often have, for instance, longer-term debt and tend to have strong relationships with banks. In addition, we believe that in many cases, management is highly incentivized to regain the investment grade credit rating. Ford is a great example – the company was able to regain ownership of its own logo once it became an investment grade company again this year. Perhaps an even more compelling argument for us, though, is the concept of buying “after the news”. In other words, fallen-angel bonds enter the fund’s index the month after they have achieved an average rating of below investment grade. What we have seen is a lot of selling even before the downgrade and some degree of forced selling afterward. In our view, many fallen-angel bonds end up losing much of their value before they enter the index, or before ANGL buys them [see Monthly Dividend ETFdb Portfolio].
ETFdb: What separates ANGL from other high-yield corporate bond funds on the market?
FR: ANGL has a singular focus to capture this fallen-angel niche in the high-yield market. Though similar in yield at the moment to other high-yield funds, ANGL currently has a much higher percentage of BB credits (almost 70% versus about 45% among the broader HY market). ANGL also presently has a larger financial sector allocation than most other high-yield funds. That aspect of ANGL has proven to be quite valuable in 2012, contributing positively to returns, as this subordinated debt of global and large regional lenders has been the target of many buy backs [see ANGL Fact Sheet].
ETFdb: Why does it make sense to use an ETF for investors looking to pursue this sort of strategy?
FR: There are several reasons. First, we very much like the fallen-angel concept and believe a passive strategy is an effective way to be exposed to it. Second, ETFs generally offer this type of exposure to investors at lower fees than other fund formats. Third, we think credit ETFs in general may offer a less expensive way to access these less liquid markets in a more cost efficient manner than many investors would be able to achieve by investing in these bonds individually.
ETFdb: Aside from attractive dividend distributions, what else might investors find appealing about this asset class?
FR: In the right environment, we believe in the potential upside of this asset class. According to a study by Moody’s, fallen angels that avoided default after two years were more likely to be upgraded to investment grade than original issue high-yield bonds. This may be primarily because fallen angels that survive the distress and liquidity risk associated with altering their business models after being downgraded typically have unencumbered assets, helping to provide the firm with access to the capital markets by secured financing. Many fallen angels also have “franchise strength and business incentives” that enable them to repair their balance sheets by issuing equity and eventually gaining lines of credit [see also Senior Bank Loans: High Yield With Perks].
According to Standard & Poor’s, defaults in this segment are well below the 4.5% historical average for all U.S. high yields, and yields remain attractive, given the overall credit quality, in comparison with broader high-yield markets. Like other high-yield bonds, fallen angels could be vulnerable to rising risk of defaults or downgrades if the U.S. economy enters a deep or lengthy recession.
ETFdb: What are some of the longer-term trends that you are seeing in the global fixed-income market?
FR: We have seen growing comfort with non-traditional fixed income investments among a wider range of investors. This shift may be in part a result of need – as investors simply cannot achieve their yield targets via their traditional fixed income portfolios. So we are seeing a lot more interest in high yield, emerging markets credit, emerging markets local currency, REITs (real estate investment trusts), preferred securities, and other ways to obtain income. While the search for yield may reverse, we do believe that many of these asset classes have, in the meantime, gained acceptance as permanent, strategic allocations within fixed income portfolios.
Bottom Line: With interest rates expected to remain at record lows, investors have started to shed their bias towards traditional bond holdings in search of more attractive distributions. The fallen angel asset class warrants a closer look from anyone scouring the high-yield debt universe as these securities stand to offer a compelling risk/return profile along with a a juicy yield.
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Disclosure: No positions at time of writing.
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