The road back: are Fallen Angels and Rising Stars in the fast lane?

Incremental returns from high yield

In our view, the Fallen Angels (FAs) subset within the corporate credit markets continue to represent an attractive opportunity for investors seeking incremental returns from high yield investments. FAs represent former investment grade issuers that have been downgraded below BBB- into the high yield sector. When COVID-19 struck developed countries in February 2020, the FA market, as measured by the face value of the ICE BofA Global Fallen Angels index (Ref. HWFA) was US$209 billion. By the end of 2020 that had grown to US$509 billion as rating agencies downgraded issuers, such as Ford and Kraft Heinz. By July 2021 it had declined a little, but only to US$472 billion. 

‘Fallen Angels, often carrying debt levels more akin to investment grade companies, will be motivated to recover that status as soon as they are able, to help keep the costs of that and future borrowing as low as possible’
 

However, historically Euro FA returns have exceeded those of both Euro investment grade credit, the Euro BBB rated index as well as the Euro BB sector they typically form part of. The Global FA index has fared even better, supported by the even stronger returns US FAs have typically achieved, reflecting the acceleration in the US economy relative to Europe. We believe the size of their outstanding debt would suggest the management of FA companies will be highly motivated to achieve a return to investment grade ratings quickly.

A path towards an upgrade to investment grade

The high yield opportunities also extend to issuers whose credit fundamentals are improving and on a path towards an upgrade to investment grade. These ‘rising stars’ represent a further opportunity where deep credit research can identify potential upgrade beneficiaries ahead of rating agency actions. We have observed a number of BB issuers that we believe are candidates for upgrade to investment grade. To us, these tend to appear more attractively priced compared with many BBB rated bonds, which have become increasingly expensive due to ongoing quantitative easing purchases. It is notable that the high yield upgrades/downgrades ratio high yield has been accelerating recently, to its highest in ten years. 

Despite the good performance of Fallen Angels and rising stars relative to the rest of the corporate markets, we believe high yield credit spreads have scope to decline further. Having peaked above 650 basis points (bps) in March 2020, almost 400bps above the spread on the Euro BBB Non-financial corporates index, Euro BB credit spreads still remain more than 100 basis points wider than the BBB non-financials index spread. We believe this leaves plenty of room for the market to discount future rating upgrades of improving fallen angels and rising stars.

Identifying issuers likely to be upgraded to investment grade status earliest may help towards generating attractive returns, and we believe managers with a strong focus on credit research are well placed to capture those opportunities in advance of a credit rating change.