Fallen Angels: Your Solution for High Yield Without High Risk

The answer may lie within the fallen—Fallen Angel bonds, that is.

These once investment-grade bonds turned junk could be the answer to getting high income without much more risk. For investors, Fallen Angel bonds could be one of the best deals in the fixed income marketplace these days. The best part is accessing them is a breeze.

Bonds essentially fall into two camps: high yield and investment-grade. There’s plenty of nuance between these two camps and the groups are defined by their credit ratings. The major credit rating agencies—S&P Global, Fitch, and Moody’s—will periodically check in on a company and re-evaluate their ratings. This is especially true when a negative or positive event occurs, such as a buyout, legal windfall, a major write-down, etc.

Sometimes, those events cause the ratings agencies to push a firm’s credit rating lower. A firm takes on too much new debt, business trends start to deteriorate or they pay too much for another firm or expansion plan. Anything that negatively impacts their cash flows and ability to pay back their bonds can result in a downgrade.

Usually, if a firm falls one notch down in the investment-grade group, nothing really happens. The same could be said for junk/high-yield bonds. But for those firms that straddle the line between investment-grade/high yield with a rating of BBB, things get a bit complicated.

These bonds are known as Fallen Angels. And this status affords them some strong benefits for portfolios.

Typically, these bonds will fall in price when the credit rating threshold is breached. That’s because investment-grade bond funds are forced to sell them to meet their mandates. Perhaps worse is that they are selling them into an illiquid market. For investment-grade debt, it’s easy to find buyers. Trying to sell a bond issued by Microsoft or Coca-Cola is pretty easy. That’s not the case for junk bonds, even formerly investment-grade ones.

It’s this selling and former top-quality status that could bring big gains for investors.

A slight dip in credit rating doesn’t impact a firm’s ability to repay bonds. As we said, going down one notch or two doesn’t significantly impact cash flows or balance sheet strength. This makes Fallen Angels a lower credit risk than other junk debt.

Thanks to that initial selling, Fallen Angel bonds often pay more than lower credit-rated debt or slightly higher-rated debt. For example, the Bloomberg U.S. High Yield Fallen Angel 3% Cap Index is currently paying a juicy 7.2%. That’s more than high-rated BBB and lower-rated BB bonds. Moreover, that yield is nearly on par with the Broad High Yield Average. This chart from Insight Investment sums up the yield advantage.

Source: Insight Investment

The third win for Fallen Angels comes in terms of capital gains. As time goes on, and these bonds continue to repay their coupons and get closer to their maturity dates, investors take notice. Prices for these bonds will often start to increase and get closer to par values until eventually they mature and investors receive par values back. This extra capital gains boost is what has allowed Fallen Angles to outperform the broader high yield and investment bond universes over the long haul. According to Insight Investment, you are looking at extra returns over yield in the 2.5% to 3% range on average.

The best part is that today’s environment makes perfect sense for Fallen Angel bonds.

For starters, the credit risk-to-yield ratio is very good. This gives investors a chance to score higher income without taking on too much default risk. An extra 2% in yield is nothing to sneeze at by only moving one step down the rating ladder. That higher credit rating is wonderful during recessions. Default rates for Fallen Angels are much lower than other forms of junk debt.

Second, the par value plays well in a recession. Fallen Angels have done well during a recession thanks in part to their par values and repayment of that cash. After all, there’s plenty of value in coupon clipping during recessions versus equities that may take longer for an investor to break even.

Finally, Fallen Angels tend to do well no matter what the rate environment. According to Van Eck, the ICE U.S. Fallen Angel High Yield Index over the last 20 years has produced positive returns in each of the Fed’s tightening cycles. At the same time, rate cuts are great for high yield bonds as cash flows tend to increase and firms face fewer issues paying back their loans. Given the uncertainty amid Fed policy, this puts Fallen Angels in a unique position to win no matter what the rate environment looks like.

Given that Fallen Angel bonds could be a top choice in the fixed income sector, investors may want to grab them. However, the lack of liquidity remains an issue. It’s tough to build a portfolio of individual Fallen Angels on your own.

Luckily, the ETF revolution has come to the sector and investors have some opportunities to own these bonds in a broad, single-ticker package. Likewise, there are several active mutual funds in the high yield category that include these bonds in their mandates.

These funds were selected on their exposure to Fallen Angel bonds. They are sorted by their YTD total return, which ranges from -0.6% to 2.7%. They have expense ratios between 0.15% to 1.02% and assets under management between $34M to $3.03B. They are currently yielding between 4.5% and 6.3%.

Overall, Fallen Angel bonds are a unique asset class among fixed income sectors. Straddling the line between junk and investment grade, these bonds offer the potential for high yields and capital gains without that much more in credit risk. With that in mind, investors want to consider these bonds for the current environment. They can have their cake and eat it too.

Finding strong yields without taking on too much credit risk is of paramount concern these days. Fallen Angel bonds may be the answer. These former high flyers and now junk bond superstars offer the right blend of yield and credit risk for portfolios. No wonder why they have outperformed over the long haul.

¹ Insight Investment (April 2024). Fallen Angels Q&A: Taking opportunity from mispricing