An Angelic Idea for Second-Half Bond Allocations

There’s not been much rest for weary clients on the fixed income front this year, but there are some positive signs emerging.

Added good news comes in the form that some of that still nascent ebullience comes by way of high-yield debt – a relief to income-starved investors. Yes, interest rates are rising, but real yields across much of the municipal and Treasury landscapes still aren’t attractive.

Fortunately, there are reasons for advisors to at least evaluate high-yield debt, including fallen angel bonds. Among those are reasons are still modest default rates and data suggesting the specter of a recession isn’t being reflected in the junk bond market.

“Between December 1996 and December 2021, there were 28 months when the economy was in recession, according to an analysis by Martin Fridson, chief investment officer at Lehmann Livian Fridson Advisors. The median junk-bond spread during those months was about 835 basis points, or 8.35 percentage points, based on ICE BofA indexes. That spread is currently closer to 460 basis points, around the median level for non-recession months, according to his analysis,” reports Bloomberg.

For advisors searching for a more conservative approach to junk bonds with still enticing yields, fallen angels could be the answer.

Assessing Fallen Angel Advantages

Fallen angels are unique in the high-yield debt space because these bonds are born with investment-grade ratings and are later downgraded to junk status. As a result, fallen angels have superior quality traits and, historically, better performance than bonds born directly into junk territory.

For advisors, those are relevant considerations 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.

“From that perspective, there could be opportunities to add exposure at more attractive levels. However, with consensus expectations for a growth slowdown or recession on the horizon, the potential for even wider spreads remain, even if the rate outlook may become more favorable,” according to VanEck research. “Compared to a broad high yield exposure, however, we believe fallen angels may outperform in such an environment given significantly higher weighting towards higher quality BB-rated bonds, which may outperform lower rated bonds in periods of volatility.”

Asset allocators that believe in historical trends may find fallen angels alluring, too. The reason being is that this asset class usually isn’t given to extreme price action, but when such scenarios arrive, they’re often harbingers of good things to come.

“To add context, there have been 9 instances since December 2003 where the current price crossed from above the historical average price. Typically, the year after prices crossed, fallen angels have outperformed broad HY by 3.05%. Over the course of the following 3 years, outperformance has been 8.78% and it becomes wider over the following 5 years, 17.60% (in price terms),” adds VanEck.

Fallen Angels: When Quality Matters

As noted above, fallen angels feature more quality than junk bonds. However, as advisors know, there are periods when the junkiest junk bonds outperform those with higher credit ratings.

Over the long haul, however, quality wins out across all asset classes and that’s certainly the case with high-yield bonds.

“Most sell side shops prefer higher-quality balance sheets as economic growth continues to slow down with BB rated issuers having stronger ability to adapt to the transition to a later stage of the business cycle. We believe the higher quality tilt of fallen angels may provide a strong cushion against spread widening and volatility if growth concerns continue to grow,” concludes VanEck.

Related: Green Shoots Emerging for Municipal Bonds