Fallen Angel ETFs Show Their Good Side

Higher interest rates and prices aside, issuers of risky corporate bonds are largely making their payments on time. So far this year, 13 junk bond issuers have defaulted, according to Fitch Ratings. That’s a 1.2% default rate, below the historical average. 

That may not have occurred to someone looking at the performance of junk bond exchange-traded funds this year. The two largest funds in the arena, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the SPDR Bloomberg High Yield Bond ETF (JNK), are down by 12% and 13.3%, respectively, this year. 

Both funds are now yielding 8%-9%, double what you would get at the low point for yields in 2021. 

Rising Rates & Credit Spreads  

The decline in junk bond prices and the spike in their yields (bond prices and yields move inversely) is not just a function of how investors see the economy; the Federal Reserve’s rate hiking campaign has been the biggest driver of junk bond returns this year in 2022. 

But worries that the Fed’s rate hikes could push the U.S. economy into a recession have played a part, too. The yield spread between junk bonds and Treasuries with similar maturities is almost 5%, well above the less-than-3% premium they had last year. 

Those widening spreads reflect investors’ worry that an increasing number of junk bond issuers won’t make their payments if the economy weakens noticeably. This remains to be seen because U.S. economic growth has proven resilient so far.

Fitch forecasts that the number of junk bond defaults will rise next year to a relatively low total of 30. That would equal a default rate of 2.5%-3.5%, below the 3.8% 21-year historical average. The rival credit rating agency Moody’s forecasts a slightly higher default rate of 4.3%, but nothing cataclysmic. 

Still, those forecasts assume only a modest slowdown in the economy, and something more severe would cause greater defaults. Moody’s worst-case scenario envisions the default rate surging to 13%. 

Higher Quality Junk Bonds  

For investors in junk bond ETFs, the default rate will play a key role in determining their actual returns. A decade ago, HYG was yielding 5.7%, but its actual annual return over the past 10 years has been 3%, diminished by rising rates and above average defaults in 2016 and 2020. 

An alternative junk bond strategy, which has outperformed both HYG and JNK, is to invest in fallen angels. The VanEck Fallen Angel High Yield Bond ETF (ANGL) and the iShares Fallen Angels USD Bond ETF (FALN) invest only in bonds that once had good credit ratings, also known as “investment-grade bonds,” and were subsequently downgraded to subinvestment-grade, or junk bond, territory. These are known as fallen angels.  

These are the highest quality of junk bonds, and they have historically had lower default rates than the overall junk bond category. Companies whose bonds have become fallen angels also have an incentive to get those bonds upgraded back to investment grade. That results in higher prices for those bonds—and the ETFs that hold them.  

Over the past decade, ANGL has returned 5.5% per year, almost double the returns of HYG. On the other hand, this year it’s underperforming, with a 16.7% loss. That can be attributed to the greater interest rate sensitivity of fallen angels compared to the overall junk bond market.  

Today, yields on ANGL and FALN are slightly less than HYG and JNK, at around 7.5% to 8%. 

Email Sumit Roy at [email protected] or follow him on Twitter @sumitroy2