This Could Be Ideal Bond Play in 2023

Advisors and clients alike are likely leery of fixed income allocations in 2023 owing to the fact that 2022 was one of the worst years on record for broader bond benchmarks.

While some corners of the bond market were better than others last year, some were downright ugly. Interestingly, high-yield corporate bonds, broadly speaking, outpaced diversified fixed income indexes last year. That can be viewed as somewhat surprising when considering Treasury yields spiked and recession speculation increased.

To be sure, there are expectations in place that if an economic contraction materializes in earnest this year, junk bond defaults could rise, albeit modestly. Indeed, headwinds could emerge, but high-yield bonds could be points of consideration this year for income starved, particularly if Treasury yields decline and default rates remain tolerable.

Fallen angel bonds – corporate bonds born with investment-grade ratings and later downgraded to junk – could prove pertinent in this year’s fixed income conversation.

Fallen Angel Advantages

For advisors, the quality and income traits offered by fallen angels are relevant at a time when clients are likely still apprehensive regarding fixed income allocations, particularly those of the high-yield variety. Those apprehensions are warranted, but after an arguably undue drubbing in the first half of this year, there could be lingering opportunity with fallen angels.

Adding to the allure of fallen angels is that after last year’s tumble, there is some value available in the group with data confirming as much.

“The yield to worst for fallen angels (7.49%) is now above the historical average (7.06%), providing a level where adding exposure may be attractive for investors as the higher level of carry offers a significant cushion for returns in a range of potential rate/spread scenarios (including upgrades/downgrades) going forward,” according to VanEck.

To be sure, credit spreads remain wide and could widen further as bond market participants price in a recession. In favor of fallen angels, issuer fundamentals are sound and spreads continue hovering around 2020 levels. Speaking of spreads, if they blow out on investment-grade corporates, that could be supportive of fallen angels.

“Wider spread environments with weakening fundamentals would most likely lead to an increase in fallen angel volume, which has driven outperformance of fallen angels versus broad high yield historically,” adds VanEck. “The ability to earn a high level of carry, and the higher overall credit quality of fallen angels, may make fallen angels an attractive place for high yield investors to wait for a turn in the credit cycle.”

Fallen Angels Could Be Interesting in 2023

Fallen angels stumbled last year, but a sequel is unlikely this year as sector risk diminishes and if Treasury yields decline.

“The corporate fundamental backdrop may become more challenged, translating into sector dispersion and potentially some defaults, with the expected high yield default rate increasing to 2-3% by December of 2023. Upgrades may continue their momentum in 2023 and some issuers (Occidental Petroleum, Ford, etc.) are on a good deleveraging path and will most likely see their credit ratings improve,” concludes VanEck.

Treasury yields are integral in the fallen angel equation because these bonds are usually longer duration than standard junk debt. That’s the trade-off for higher quality and strong long-term return potential.

Related: Inflation Still Thorn in Side of Advisors and Investors