Fallen angel ETFs primed for take-off

Jun 10th, 2020 | By | Category: Fixed Income

ETFs providing exposure to fallen angel bonds appear primed for take-off as these funds have historically outperformed the broader high-yield market following a surge in downgrades.

Fran Rodilosso, Portfolio Manager, Head of Fixed Income ETF Portfolio Management at VanEck.

Fran Rodilosso, Portfolio Manager, Head of Fixed Income ETF Portfolio Management at VanEck.

This is according to Fran Rodilosso, Portfolio Manager and Head of Fixed Income ETF Portfolio Management at VanEck.

Rodilosso recently shared his perspectives with an audience of investors in a webinar hosted by VanEck and co-promoted by ETF Strategy. (Replay | ‘Fallen Angels: High Yield Through the Credit Cycle‘)

Rodilosso noted that, due to the economic fallout from Covid-19, the number of new fallen angels – bonds that were rated investment grade on issuance but have since fallen to high-yield status – has already reached a record 42 issuers globally this year, representing over $200 billion in debt by market cap.

Cyclical sectors such as financials, energy, and consumer discretionary have recorded the highest number of downgrades, reflecting the pandemic’s severe economic impact.

With the global economy’s recovery uncertain, and rating agency decisions tending to lag the market’s moves, Rodilosso predicts a further $200bn in fallen angel debt could materialize by the end of the year.

Yet, the sharp economic contraction that sparked this record wave of downgrades bodes well for fallen angel ETFs with Rodilosso highlighting that timing is the strategy’s key performance driver.

The fallen angels investment thesis is based on the premise that the overly negative sentiment surrounding a downgrade into junk status causes fallen angels to be regularly oversold as investors (often forced by their investment mandate) sell en masse prior to and at downgrade, leading to a price anomaly.

Rodilosso points out that, historically, fallen angel bonds globally have sunk 7%, on average, during the six months leading up to their downgrade; however, they will typically recover that value over a subsequent six month period.

VanEck’s global fallen angel ETF, the Europe-listed VanEck Vectors Global Fallen Angel High Yield Bond UCITS ETF (GFA LN), aims to capture that rebound by including new fallen angels at the end of the month during which the bond’s average credit rating crossed into high-yield territory.

The underlying ICE BofAML Global Fallen Angel High Yield Index covers fallen angel bonds issued by corporate entities in developed or emerging markets and denominated in US dollars, euros, pound sterling, or Canadian dollars.

The fund is listed on London Stock Exchange in US dollars (GFA LN) and pound sterling (GFGB LN), on Xetra (GFEA GY) and Borsa Italiana (GFA IM) in euros, and on SIX Swiss Exchange (GFAA SE) in Swiss francs. It comes with an expense ratio of 0.40%.

Source: VanEck.

While the pace of new fallen angels entering the index is at a record high, the current investment case may be further strengthened due to discounts being particularly large compared to historic levels. Rodilosso notes that new fallen angel bonds in 2020 have experienced a 20% price decline over the two to three month period leading up to their downgrade, although this is somewhat reflected in the broader market’s sell-off.

The average credit quality of fallen angel bonds is also superior to that of the broader high-yield market, another reason why the strategy has outperformed over the long-term. According to Rodilosso, a tilt to superior credit quality within the high-yield universe can act as a buffer when credit spreads widen. He notes that the majority of fallen angel bonds will never slip below BB – over 83% of the global fallen angel index’s exposure is currently allocated to this credit bucket – which is likely to appeal to investors who do not want to venture deep into junk territory.

Yet the strategy is also not heavily dependent on any particular stage of the credit cycle. Rodilosso notes that the index has outperformed the high-yield market on an absolute and relative basis for 11 of the past 15 calendar years. Over this 15-year period, the index has returned 7.2% per annum with a 9.0% standard deviation, compared to a 5.4% return and 8.0% standard deviation for the broader market. Its Sharpe ratio of 0.71 is, therefore, superior to the 0.57 ratio for the global high-yield market.

The outperformance of the fallen angel strategy is also driven by its tendency to take a contrarian approach and provide exposure to sectors where fundamentals have bottomed out.

Following the recent slew of downgrades, the index’s largest sector exposure is energy at 31.9%, roughly 18 percentage points higher than the high-yield universe. The automotive, banking, and consumer goods industries are also overweight, each by roughly 5 to 7 percentage points. The most underweight sectors are real estate and media (approximately 5 and 7 percentage points respectively), both of which have underperformed the broad market this year.

Source: VanEck.

Roughly two-thirds of bonds in the index are from corporate issuers in developed markets with the remaining third by firms in emerging markets. Rodilosso notes that price dislocations in emerging market fallen angels have been even greater than their developed market counterparts; however, he highlights that emerging markets do pose their own unique set of risks.

Bonds from US-domiciled issuers account for 44.7% of the index weight, followed by Mexico (15.2%), Italy (8.5%), and Brazil (7.0%), although Rodilosso points out that geographic exposures do not play as significant a role compared to sectors in driving performance.

Investors should note that fallen angel bonds typically exhibit higher interest-rate risk than the broader high-yield market; however, interest rates are expected to remain low while central banks continue to combat the Covid-19 fallout. The index currently has an effective duration of 5.5 years, compared to 3.9 years for the broad high-yield market which is roughly in line with historical levels.

When asked about transaction costs, Rodilosso did concede that turnover is higher during periods when large numbers of new fallen angels are entering the index. He did note, however, that these periods are also characterized by ample liquidity on the buy-side for these bonds due to the forced selling by investors with investment-grade mandates. In particular, Rodilosso highlights that ETF market makers are incredibly adept at working together to keep these transaction costs low.

Rodilosso was also asked whether there were any circumstances under which the ETF may avoid holding a fallen angel bond, perhaps due to a particularly negative outlook for that company. He noted that the underlying index is 100% rules-based, a feature that allows it to maintain complete transparency. While this rules-based process lays open the possibility that the fund will end up holding some so-called “fallen knives”, research indicates these default losses are not worse than the broad high-yield market. More importantly, the ETF is assured to fully capture the rebound associated with “rising stars”, fallen angel bonds that reclaim their investment-grade status.

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