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Should You Invest in Fallen-Angel Bonds?

Sumit Desai, CFA

Sumit Desai: Hi, I'm Sumit Desai--senior fixed-income analyst with Morningstar's manager research group. Joining me today is Fran Rodilosso, senior investment officer for fixed-income ETFs with Van Eck.

Fran, thank you for joining me today.

Francis Rodilosso: Thanks, Sumit. Thanks for having me.

Desai: We're here today to talk about the Market Vectors Fallen Angel High Yield Bond ETF (ANGL). Can you talk a little bit about what a fallen angel is and the role that a fallen-angel bond or issuer plays within the high-yield market?

Rodilosso: Fallen angels are bonds that were originally issued as investment-grade bonds. So, the issuer typically has gone through some type of credit issue that's led to a downgrade--or series of downgrades--that's brought the bond into the sub-investment-grade universe. Interestingly, fallen angels are bonds, not the issuers themselves. So, if an issuer issues a bond after their credit rating is sub-investment-grade, that bond would not be considered a fallen angel.

How do fallen angels fit into the general context of the broader high-yield market? Well, they were the original high-yield bonds; the original junk bonds were fallen angels. Today, they make up about 13% of the broader U.S. high-yield universe, so there is a lot more original-issue high yield out there now than there are Fallen Angels.

Desai: Given your comments and given that sometimes a bond will become a fallen angel if there is a deteriorating credit-quality issue, what makes this segment so attractive for investors?

Rodilosso: What happens is that there is usually some type of credit deterioration that has led to the downgrades; but consistently, fallen angels have remained in the BB category. So, versus a broader high-yield market, it generally has remained a higher-quality segment of the high-yield universe.

Also, there is a little bit of a value proposition in how it all plays out. In other words, as credit-rating downgrades are anticipated by the market, usually those bonds lose a significant amount of the value that they're going to lose by the time the downgrade actually happens.

So, by the time they enter this index, which is the month after the downgrade that puts them into the high-yield category, I think Merrill Lynch did a study once that said the bonds have typically lost about 80% of the value that they lose in total. But a key component is that today the Fallen Angel Index is about 80% BB issuers--BB+, BB-, or BB--versus about 47% of the broader high-yield market.

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Desai: It seems like there could be some heightened credit risk if the deterioration is worse than expected. Can you give an example of some of the types of companies that fall into this category?

Rodilosso: There are some very well-known companies, and that's one of the qualities of fallen angels typically--they were an investment-grade issuer. So, they may be a firm that has a long-established history, a large asset base, and so on. Some well-known names today that are in the index: ArcelorMittal (MT), a big global steel company, is one of the larger names in the index; some smaller ones that are still well known--JCPenney (JCP), Dell, Sprint (S). A very well-known fallen angel from about eight years ago that re-emerged and became investment-grade again was Ford (F).

JCPenney, by the way, is one of those companies that you mentioned that had continuation of deteriorating credit quality. It's no longer a BB issuer.

Desai: To that point, obviously what drives returns for the high-yield space over the long term is really going to be dependent on default ratios. What is the default profile for a fallen-angel bond relative to a regular high-yield bond?

Rodilosso: Edward Altman does great studies on histories of bond defaults. His 30-year history of fallen angels puts it almost a percent below the average annual default percentage for original-issue high-yield bonds. Original-issue high-yield bonds have somewhere around a 4.5% annual default rates on average, and fallen angels are closer to 3.6%.

According to Altman's numbers, the last few years, neither category--original issue or fallen angel--have had very high default rates at all, usually below 1%. We're in a fairly low-default-rate environment. Probably more importantly--or as important--fallen angels have had a higher ratio of becoming investment-grade again than original-issue high yield. So, they've defaulted less on average, historically, and ascended to investment-grade at a higher rate on average as well.

Desai: When investors want to look at this segment of the market, going forward, you mentioned that a big portion of the benchmark is within that BB tranche. That's generally known as an area where it's a little bit more interest-rate sensitive than lower-quality areas. So, how would you expect this segment to react in a rising-rate environment?

Rodilosso: A very fair point. There should be a higher sensitivity to interest-rate movements, particularly in the five- to 10-year range of, say, Treasury moves, which doesn't necessarily correlate with moves in Fed funds. So, for instance, in a rate-hike environment and a curve-flattening environment, high yield, in general, may do OK and so may fallen angels; but also, by the way, since many fallen-angel bonds, while they are all original-issue investment-grade, many were issued at longer than 10-year maturities. So, the duration on the Fallen Angel Index is a little over a year longer than the duration on the broader high-yield market. It's in the mid-fives versus that the mid-fours.

So, [fallen angels have] higher interest-rate sensitivity from that perspective. And from the perspective of tighter spread in the BB category, so lower cushion.

That being said, both the broad high-yield market and fallen angels, over the last five and 10 years, have shown a slightly negative correlation to the performance of 10-year Treasuries and a slightly positive correlation to the performance of 5-year Treasuries--but near negligible.

I think when you talk about higher interest rates today and things that may happen over the next year if you have something like a taper tantrum and it's a risk-off reaction to the prospect of higher interest rates, that's a different impact from the direct impact of higher rates. And risk-off is generally not good for high yield--broad market or angels. But there have been four or five years since the Fallen Angel Index came into existence where either Fed funds or the five-year yield has increased by more than 1%. Each of those years, both the high-yield market and fallen angels have actually had positive years, and fallen angels outperformed the broader high-yield market in four of those five years.

Desai: One of the concerns across high yield that we've heard about over the past few months is exposure to the energy sector with falling oil prices. A lot of energy companies issued debt at higher oil prices, and that has affected the market. How does the [energy-sector exposure within the fallen-angel world compare with that of the broader high-yield world], and what are the other large sector exposures within the portfolio today?

Rodilosso: Good question. The sector exposure has definitely changed over time pretty dramatically in the Fallen Angel Index because if an entire sector is going through a period of distress, you may see a large number of fallen angels. Before I get to energy, looking back to 2005-06 automotives--I mentioned Ford earlier. It wasn't just Ford; it was a lot of the finance companies, too. It became, by far, the largest sector within the index.

In 2012, financials--mostly subordinated bank issues by big U.S. banks--became about 30% of the index. But back to energy: Today, it's about 11.5% of the Fallen Angel Index versus roughly 14.5% of the broader high-yield market. A year ago, it was 4.5% in fallen angels and about 18% in the broader high-yield market.

So, there is capital loss in the sector. In high yield, that brought the weighting down. What's happened in fallen angels is that several new energy companies have entered the index--the largest being Transocean (RIG), which was downgraded to sub-investment-grade status earlier this year. So, at 11.5%, it's catching up. I guess the good news is it's been catching up as bonds have been losing value.

I would expect a few more energy fallen angels before year-end. So, you'll probably see a similar weighting in angels versus the broader high-yield market by the end of the year. The other large sectors, by the way: Basic industry, where something like ArcelorMittal would fall into, is about 20% of the index; banks are the next-largest sector in the high teens; then, energy and telecommunications are in the low teens.

Desai: Given the wide variety of options investors have in terms of accessing the high-yield market, what would you suggest is the best way for investors to use this type of ETF?

Rodilosso: I think there's a value proposition within fallen angels, which we talked about earlier. Two things to keep in mind: The tendency for fallen angels to have lost a lot of their value before they enter the index is number one, and number two is the higher propensity to come back into the investment-grade world, which gives some capital-appreciation potential.

Think of it as close to crossover, the BBB/BB segment, with that value proposition. So, for investors who still want exposure to high yield but may be willing to give up some yield for the higher-credit-quality end of the spectrum, I think this is a good choice. Use it as a substitute or maybe an overweight within your high-yield allocation overall.

Desai: Fran, thank you for taking the time to join us today.

Rodilosso: My pleasure, Sumit. Thank you.

Desai: Thank you.