May 19, 2020
Today’s economic environment has prompted credit rating agencies to downgrade a substantial amount of debt from companies. However, with the right fundamentals, some bonds may offer compelling valuation opportunities, according to Paul Benson, head of fixed income efficient beta at Mellon.
Fallen angels, or investment grade bonds downgraded to high yield, can create attractive entry points for bonds with equity-like returns and fixed income-level risk. However, when these bonds are downgraded, some portfolio managers end up selling them.
Why do they sell?
As a company’s financial performance deteriorates, whether it’s due a black swan event or mismanagement of funds, rating agencies will downgrade its bonds. This can create a forcedselling scenario among investors who can no longer continue to hold these bonds.
“On the active side, portfolio managers may sell if their strategy’s investment guidelines, which often have a high-yield threshold, limits them from holding additional below-investment grade debt,” says Manuel Hayes, senior portfolio manager of the Mellon Efficient Beta Fallen Angel Strategy.
Passive managers, who focus on managing tracking error, naturally sell out of these bonds during monthly rebalancing, leading to steep discounts, according to Hayes.
So where’s the alpha?
The investment grade bond market is roughly US$6 trillion in size and nearly five times the size of the high-yield market.1 Forced selling can send ripples of disruption through the high yield market, creating a supply-demand imbalance.
“There’s a large component of investment grade managers who have to sell these bonds, which have been downgraded to a market smaller in size,” Benson says. “When you have this influx of downgraded fallen angel bonds, entering the high yield market at a very fast pace because of forced selling, there tends to be a technical indigestion.”
This ‘technical indigestion’ results in about 200 basis points (bps) of discount relative to where fair value should be for these bonds, according to Benson.2 The key is to identify those fallen angels that are underpriced relative to the broad high yield market.
“If you can systematically invest at the time of the peak discount, we believe you’re able to harvest this structural alpha component,” Benson says.
Aside from valuation opportunities, fallen angel bonds can also offer an attractive risk-return profile. For instance, about 85% of fallen angels have a BB rating while only 50% of the broad high yield market is comprised of BB-rated bonds. The other 50% of the broad high yield market is mainly comprised of B and CCC-rated bonds.3 This means the sub universe of fallen angels has lower default risk than the broader high yield universe.
According to Hayes, there are three reasons why the time could be right to invest in fallen angels:
- Increased pace of downgrades leads to large opportunity set
- It’s an attractive entry point from a spread/yield perspective
- The Federal Reserve (the Fed) is buying fallen angels now
The fallen angel space is only growing, which means more opportunity to invest in downgraded bonds at a discount. Over the last 10 years, rates have been low so companies have continued to issue more and more debt, according Hayes. However, the pandemic has caused lower corporate earnings and a weaker economic outlook. Now, some companies, which may not have been cautious enough, are being downgraded by rating agencies.
“A higher amount of downgrades means more investors are forced selling, which means larger discounts and potentially high returns,” Hayes says. “Over US$150bn has been downgraded year-to-date and we’re four months into it. That number has exceeded every full calendar year.” “On the sell-side, we hear analysts projecting anywhere from another US$200bn to US$700bn in fallen angel downgrades taking place from now until the end of this year.”
Secondly, wider option-adjusted spreads (OAS) during March offer a wider entry point, which should be more compelling to investors. At the moment, OAS spreads are at roughly 750 bps,4 which Hayes says is still an attractive entry point, at levels not seen since the Great Financial Crisis.
Lastly, the Fed is currently buying fallen angel bonds, which Hayes says is supportive of valuations. On April 9, the Fed announced it would expand its primary and secondary market corporate credit facility to include fallen angels, which impacts both bonds and ETFs. On the bond side, US$500bn will be supported on the primary market and US$250bn on the secondary market. On the ETF side, it announced it would buy broad-based corporate bond ETFs.5
On May 4, the New York Fed provided more insight into the program, stating if a recently downgraded company wants to opt into the primary credit market and have the Fed purchase its debt, there is compliance criteria that must be met—but if met, it would step in as last resort lender. It also announced it would start buying broad-based corporate bond ETFs in early May if they meet certain valuation criteria.
“This is very supportive of valuations. On the bond side, the high-yield market rallied 86 bps on the back of this initial announcement. That’s one of the largest single-day moves in high-yield market history,” Hayes says.
“On the ETF side, we saw 6% returns intraday into broad high yield ETFs. From a valuation perspective, this only further reinforces why we think the time is now to invest in fallen angels.”
Fallen angels may be a way for investors looking beyond the horizon to navigate today’s market environment and tap into fundamentally-sound bonds at a discount.
1 CNBC: Moody’s cuts outlook on $6.6 trillion US corporate debt pile to ‘negative’. March 30, 2020.
2 Data from Mellon Efficient Beta team
3 Data from Mellon Strategic Beta team
4 Data from Mellon Strategic Beta team
5 Bloomberg: Federal Reserve’s fallen angel bond buying won’t catch them all.
April 9, 2020.
Alpha: Then excess return of an investment relative to the return of a benchmark index. BB rating: A credit rating just below the investment grade threshold. Beta: The measure of relative volatility. Black Swan Event: An unpredictable event, beyond what is normally expected and has potentially severe consequences. CCC rating: A credit rating, which represents an extremely high risk bond or investment. Fair Value: An assets sale price agreed upon by the buyer and seller. Option Adjusted Spreads: The measurement of the spread of a fixed income security rate and the risk-free rate of return, which is then adjusted to take into account the embedded option. Spread: The difference between two comparable measures. Yield: Earnings generated and realized on an investment over a particular period of time.
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. To obtain a prospectus, or a summary prospectus, if available, that contains this and other information about a fund, contact your financial advisor or visit im.bnymellon.com. Please read the prospectus carefully before investing.
ETF shares are listed on an exchange, and shares are generally purchased and sold in the secondary market at market price. At times, the market price may be at a premium or discount to the ETF's per share NAV. In addition, ETFs are subject to the risk that an active trading market for an ETF's shares may not develop or be maintained. Buying or selling ETF shares on an exchange may require the payment of brokerage commissions.
ETFs trade like stocks, are subject to investment risk, including possible loss of principal. The risks of investing in the ETF typically reflect the risks associated with the types of instruments in which the ETF invests. Diversification cannot assure a profit or protect against loss.
Bonds are subject to interest rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines. High yield bonds involve increased credit and liquidity risk than higher rated bonds and are considered speculative in terms of the issuer’s ability to pay interest and repay principal on a timely basis.
Equities are subject to market, market sector, market liquidity, issuer, and investment style risks to varying degrees. Small and midsized company stocks tend to be more volatile and less liquid than larger company stocks as these companies are less established and have more volatile earnings histories.
Investing in foreign denominated and/or domiciled securities involves special risks, including changes in currency exchange rates, political, economic, and social instability, limited company information, differing auditing and legal standards, and less market liquidity. These risks generally are greater with emerging market countries.
Past performance is no guarantee of future results.
This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular investment, strategy, investment manager or account arrangement. Please consult a legal, tax or investment advisor in order to determine whether an investment product or service is appropriate for a particular situation. Mellon is a global multi-specialist investment manager dedicated to serving our clients with a full spectrum of research-driven solutions.
Mellon Investments Corporation (Mellon) is a registered investment adviser and an indirect subsidiary of The Bank of New York Mellon Corporation.
Views are current as of the date of this publication and subject to change. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. This information contains projections or other forward-looking statements regarding future events, targets or expectations, and is only current as of the date indicated. There is no assurance that such events or expectations will be achieved, and actual results may be significantly different from that shown here. The information in this presentation is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. BNY Mellon Investment Management is one of the world’s leading investment management organizations and one of the top U.S. wealth managers, encompassing BNY Mellon’s affiliated investment management firms, wealth management organization and global distribution companies. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may also be used as a generic term to reference the Corporation as a whole or its various subsidiaries generally. BNY Mellon ETF Investment Adviser, LLC is the investment adviser and BNY Mellon Securities Corporation is the distributor of the ETF funds, both are subsidiaries of BNY Mellon.