Fallen Angel ETFs Flying Above High Yield

When contemplating a fixed income allocation, investors must give consideration to whether they prefer to stick to the safety of investment-grade bond ETFs. Those who are willing to go out further on the risk spectrum have the option to allocate to junk bond ETFs, taking on more credit risk in exchange for higher yields.

But one specific slice of the high yield market flies in between the two categories. Referred to as “fallen angel bonds,” this term refers to bonds that were initially given an investment-grade rating but have since been reduced to junk bond status.

And these bonds have been rising above both investment-grade and high yield bonds since last spring. Since April 2021, two ETFs that offer exposure to this specific segment of high yield have seen gains of nearly double that of the broader high yield market.

Slight Differences

Investors have two options when it comes to ETFs that provide exposure to fallen angel bonds. Using the ETF Comparison Tool shows the similarities and differences between the two.

Chart courtesy of FactSet

Both the VanEck Fallen Angel High Yield Bond ETF (ANGL) and the iShares Fallen Angels USD Bond ETF (FALN) have been able to gather significant assets. FALN is slightly cheaper than ANGL, though the ETFs’ main difference is that they track slightly different indexes.

FALN’s index is capped at 3% per issuer, while ANGL’s index is subject to a 10% issuer cap. However, the differences in index construction have had little impact on performance over the long term.

Genesis Of Opportunity

Market events such as the fallout from the burgeoning pandemic last spring can create opportunity for this segment of the market. Fallen angel bonds are created through credit rating downgrades rather than issuance like other parts of the fixed income market.

Bill Sokol, product manager at VanEck, commented on just how big of an impact 2020’s market crisis had on this segment of the market: “Last year was a very negative credit environment. We saw a lot of downgrades across the board. It was the biggest year on record for fallen angels in terms of the market value.”

When events like this happen, it means the number of bonds as well as the sector composition can change quickly. The chart below shows sector allocations for the ICE US Fallen Angel High Yield 10% Constrained Index since 2004.

Chart courtesy of VanEck

Dhruv Nagrath, fixed income product strategist within BlackRock’s Global Fixed Income Group, elaborates on this idea: “FALN gives you a pro-cyclical twist because of the nature of the bonds that were downgraded last year. A quarter of the index is made up of energy exposure.”

The allocation to consumer goods and automotive also increased substantially. That pro-cyclical twist has been a factor in both FALN’s and ANGL’s strong performance as the outlook for these bonds have benefited from strong demand and reopening of economies around the world.

Buy Low, Sell High

When bonds are downgraded from investment grade to high yield, many holders are forced to sell due to being prohibited from holding below-investment-grade debt. This puts downward pressure on the price of these bonds.

Rating actions often tend to be anticipated by the market, so these bonds often see price deterioration before being downgraded and entering the index. This proves to be an advantage for fallen angel bond ETFs, as they do not hold these issues until the bond has entered the index at the lower price.

This market anticipation works the other way too. Historical data shows that bonds that go on to regain investment-grade status–known as “rising stars,”–often outperform the broader high yield market in the year prior to their upgrade. This means that much of the price appreciation happens before the bond leaves the index.

Keeping Risks In Mind

One risk that fallen angels have relative to the broader high yield market is increased interest rate risk due to their longer duration. Investment-grade bonds tend to be issued with more time to maturity relative to that of high yield bonds.

Both FALN and ANGL have a duration of over six years, while the iShares iBoxx USD High Yield Corporate Bond ETF (HYG) has a duration of three-and-a-half years. This means that the fallen angel bond ETFs are nearly twice as sensitive to movements in interest rates.

In a low rate environment where high yield spreads are close to all-time lows, this risk is important to be aware of, since bond prices have an inverse relationship with yields.

However, fallen angel bonds have yet to see the wave of upgrades for these rising stars, meaning there is potentially the possibility for further price appreciation in this space going forward.

Contact Jessica Ferringer at [email protected] or follow her on Twitter