Fixed income
Fallen angels are outpacing rising stars – Should investors worry?
4 min read 10 Jul 26
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Over the past 12 months, the number of fallen angels has exceeded the number of rising stars for the first time since 2021. What does this signal and how can high yield investors take advantage of it?
The total volume of fallen angels (bonds downgraded from an investment grade (IG) rating) has increased to $101 billion globally at the end of April. Meanwhile the total volume of rising stars (bonds upgraded from high yield (HY) status) totalled $77 billion.
An increase in the number of fallen angels is consistent with a more challenging phase of the credit cycle. Higher financing costs, a weaker macroeconomic backdrop and geopolitical uncertainty are all placing pressure on issuers. Though we often see, as the cycle evolves, conditions stabilise and upgrade activity recovers.
So, should investors be worried about the surge in fallen angels?
Currently, the relationship between fallen angels and defaults can offer some reassurance. Historically, periods of elevated fallen angel activity tend to coincide with higher default rates, with an R-squared of c.0.5, indicating a meaningful relationship. However, this relationship does not predict future changes in default rates and we don’t see any current cause for concern.
Why are we not sounding alarm bells?
Current levels of defaults and fallen angels are not signalling stress. As Chart 2 illustrates, the current combination of fallen angel volume and default rates sits below the historical trend line, suggesting defaults are lower than the level of downgrade activity would typically imply. Defaults have declined in recent months, and Moody’s expects this downward trend to continue.1
“Current levels of defaults and fallen angels are not signalling stress.”
We also see an improvement in credit quality across BBB and BB rating cohorts, with upgrades continuing to outpace downgrades by issuer count. Over the past year, 28 issuers were downgraded to HY versus 57 upgrades to IG. Euro BBs, in particular, exhibited the strongest rating performance. However, given that the global BBB market is more than four times the size of the global BB market, only a modest proportion of BBB downgrades is required to skew the figures.
Additionally, we are not currently seeing a problematic sector driving concern. In Europe, recent fallen angels such as Lanxess (chemicals), SES (media), and Verallia (packaging) illustrate the breadth of sectors affected.
Chart 4 shows the sector composition of fallen angels and rising stars over the last five years. Rising stars are heavily concentrated in financials, both banks and insurers, whereas fallen angels, aside from real estate, are more broadly dispersed across sectors.
The opportunity
It would be easy to assume that being downgraded is negative for bonds. However, it can present an opportunity; over the last 10 years, fallen angels have outperformed original issue HY by 1.2% pa in the US and 0.3% pa in the Euro HY market.
“Over the last 10 years, fallen angels have outperformed original issue HY.”
While the performance of fallen angels has been positive over the longer term, there have been periods of underperformance. This can partly reflect their typically longer duration, which weighs on performance during yield sell-offs such as 2022. As predominantly BB-rated credits, they can also lag when lower-quality parts of the market rally.
The source of outperformance is often the forced selling that occurs when a fallen angel exits the IG index. Larger capital structures can be difficult for the smaller HY market to absorb, which can push prices below fair value. This dislocation has historically unwound over time as spreads normalise.
Chart 5 illustrates spread behaviour one month either side of the point of downgrade for euro-denominated fallen angels over the past five years, relative to the BB index. Median fallen angels traded close to BB spreads in the month prior to downgrade and widened when they entered the HY index at the next month end, due to the forced selling by IG holders, before gradually compressing in the months that follow.
The active advantage
As active investors, we seek to identify and take advantage of these dislocations, capturing alpha that passive strategies may miss. Despite rising fallen angel volumes, rating migration remains positive and defaults are low. This apparent disconnect is creating opportunity, as forced selling at downgrade pushes prices away from fundamentals.
In this environment, we believe the depth of our credit research is key to identifying and capturing mispriced risk.
The views expressed on this webpage should not be taken as a recommendation, advice or forecast, nor a recommendation to purchase or sell any specific security.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.
