Finding Value in Fallen Angels
The global economy continues to face macroeconomic headwinds and growing recession risks from tightening financial conditions. In this blog, we analyze a relative value approach to fallen angels.
Valentine De Weck
History teaches us that tighter financial conditions translate into a significant uptick in downgrades. While U.S corporations show robust fundamentals and high yield markets are now generating positive returns following their worst performance since COVID, macroeconomic headwinds, nonetheless, suggest we might be heading towards the beginning of a new downgrade cycle.
Fallen Angels, bonds that are downgraded from investment grade to high yield, tend to grow to 10-30% of the high yield index market value during recessionary periods from originally ~3%, as the last three recessions suggest.
Not all investors are allowed to hold that increase in high yield asset allocation on their balance sheet and are forced to trim their position at significant discount, providing a relative value opportunity of up to 7% return over the first six months following the downgrade, for investors with excess cash and risk appetite for fresh high yield.
However, not all fallen angels are created equal! Following a downgrade, our quantitative value factor helps us identify which bonds are likely to enhance a fallen angel strategy.
Fallen Angels – a bargain deal during recession times?
This year, we have seen a significant decline in corporate bond values as the market has experienced persistent elevated inflation and heightened concerns of a pending recession. Through the third quarter of 2022, we witnessed a sharp decline in the high yield (HY) market, which declined by 14.7% according to the Bloomberg US Corporate High Yield Index. More than half of the decline can be attributed to the increase in rates as opposed to an increase in credit risk premia. Nevertheless, in the US, companies have seen a recent uptick in leverage ratios and a decline in upgrade-to-downgrade ratios, suggesting we might be moving towards another downgrade cycle in the near future.
In order to not only weather - but also benefit from a potential future downgrade storm, we use our quantitative value factor1 to identify fallen angels that may potentially outperform their peers. On average, we pick up ~12% in excess return relative to peers over the two-year period following a downgrade by selecting bonds with a high value factor score. Some investors, such as index tracking funds or insurance companies, have strict investment guidelines for their high yield allocation and many investors prohibit holding high yield securities all together. Typically, when a bond loses its investment grade credit rating, those investors are forced to liquidate the high yield position within a narrow window after the downgrade event, which leads to substantial technical pressure on the bond’s price. As a result, prices often fall below their fundamental value around the downgrade month due to the technical pressures, but then quickly revert back to their equilibrium value in the following months.
To analyze the value opportunity created by the price pressure around downgrade events, we first bucket both the fallen angels and the high yield bonds by sector, rating, and duration. Over a two-year period (ranging from 12 months before to 12 months after the downgrade of a bond), we calculate the median spread of each bucket and compare the fallen angels median spread to the one of their high yield peers (Figure 2).
The Fallen Angel Premium – A predictable and cyclical phenomenon
12 months prior to downgrade, the average relative spread of future fallen angels is about 130 bps tighter than the spread of its high yield peers (very left of Figure 2). The relative spread (fallen angel minus high yield peer) consistently increases (blue shaded area in Figure 2), turns positive the month before the downgrade event, and peaks at around 70 bps wider on the month end of the downgrade month. The relative spread then sharply reverses over the next 12 months, turning negative after six months until the equilibrium price is restored after 12 months, with a relative value spread of -40 bps from positive 70 bps at the end of the downgrade month. This strong reversal pattern suggests that there is indeed price pressure around downgrade events.
Figure 1: Fallen Angel: Market Value as % of HY Index and number of Issues. & Figure 2: Evolution of Relative Spread for Fallen Angels.
These opportunities occur in a quite predictable way: looking at evolution of US fallen angels over the past 20 years2 in Figure 1, we can see the cyclical nature of the fallen angel market volume, clustering around economic downturns. The market value of fallen angels within the Bloomberg US High Yield Index increases up to tenfold during recessionary periods. During the last three recessions, the market value of fallen angels increased from low single digits in normal years to 10-30% of the Bloomberg US High Yield index value.
Searching for Value in Fallen Angels
We quantify the yield pick-up of our enhanced fallen angel strategy by comparing fallen angels to their peers. In other words, prior to the downgrade event, the fallen angels are matched to investment-grade peers, while after downgrade they are matched to their high yield peers, based on their Sector 3 classification, broad duration profile and rating category.
Fallen angels already start to substantially underperform relative to their investment-grade peers 12 months ahead their downgrade, as much as 11% on average (Figure 3). The worst performance occurs, however, during the downgrade month due to selling pressure, which might present an attractive entry point for high yield investors. Looking at the data, we can see that in the two years following the downgrade, fallen angels outperform their high yield peers by 6% on average. Most of the relative value, about 5%, materializes in the first 6 months after the downgrade.
Figure 3: Cumulative performance of Fallen Angels relative to their peers3 for the 3-year window around the downgrade. & Figure 4: Cumulative (relative) Performance of Fallen Angels after Downgrade4.
Fallen Angel Selection – How to identify the best/worst performing asset
A simple execution of the strategy would be to buy all fallen angels shortly after their downgrade to high yield. Not all fallen angels, however, are created equal. There is a lot of performance dispersion amongst the new fallen angel investment universe, see Figure 4. While buying all downgraded issuers leads to outperformance of 6% over the two-year period, the best performing quartile of the new universe outperforms the rest by more than 12%, with half of the outperformance materializing during the first two quarters after the downgrade. On the flip side, the worst performing quartile continues to underperform their peer group over the two-year period.
A simple way to select an appealing subset of fallen angels at the time of downgrade, without forward-looking bias, would be to utilize our credit factors, in particular our value factor. The value factor identifies securities that appear underpriced relative to their fundamental anchor. The fallen angels with a high score from our quantitative value factor at the end of the downgrade month showed a very sharp 3.5% reversal in the first month after the downgrade and almost 7% after six months (Figure 5), suggesting that the value factor successfully identifies fallen angels with the largest price pressure that trade below their fundamental value during the month the downgrade occurs. On the other hand, the fallen angels that score low on our quantitative value factor underperform their high yield peers over the first 12 months after the downgrade.
Figure 5: Finding Value in Fallen Angels5.
Not all is equal, and Value can be found even in the worst economic moments
To summarize, on average, fallen angels suffer price pressure around downgrades due to forced selling. Not all fallen angels, however, are created equal. There is significant cross-sectional dispersion within the fallen angel universe. Our value factor provides a simple, transparent way to select the subset of fallen angels that deviate most from their fundamental value. We show that this value-tilted subset outperforms their characteristic-matched peers by 7% over the first six months, half of that outperformance in the first month following the downgrade to high yield.
1 The value factor identifies securities that appear underpriced relative to their fundamental anchor.
2 Sample covers about 2,000 Fallen Angels from 500 issuers for the period from January 2000 through September 2022.
3 For this analysis we select characteristics matched peers by matching Class 3 sector, rating and broad duration buckets every month. Prior to downgrade, Fallen Angels are matched to their investment-grade peers, while after downgrade they are matched to their high-yield peers.
4 This Figure shows the distribution of relative outperformance of Fallen Angels: 25th, 75th percentile along with the average cumulative performance.
5I n this Figure we analyze the subsets of Fallen Angels that have high and low value scores at the first month end after downgrade. We define issuers to be high (low) value if their sector neutralized value score is in the top (bottom) quartile relative to all issuers in the Bloomberg US Corporate High Yield Index. Cumulative performance is calculated relative to characteristic matched peers for the period since 2000.