By Nicolas Fonseca, ETF Product Analyst at VanEck.

New fallen angel bonds drive performance.

Fallen angel bonds, as represented by the ICE US Fallen Angel High Yield 10% Constrained Index, are outperforming the broad US high yield market, as represented by the ICE BofA High Yield Index, by 5.23% year-to-date, as of July 31, 2020.

This year’s new fallen angels are the primary drivers. As we have noted previously, outperformance versus the broad high yield market historically follows periods of high fallen angel volume, and this year has not been an exception.

With over $140bn of new fallen angels so far this year, it is already a record year, and we expect more fallen angel volume going forward.

From an issuer standpoint, four of the top five contributors have entered this year, including Occidental Petroleum, Ford, and Kraft Heinz.

Source: VanEck.

There are three main explanations for this outperformance:

1. The fallen angel technical effect: This has been more pronounced this year as the average six-month price return prior to entering the index for all 2020 fallen angels YTD is ~-18%, which is more than twice the historical average (~-7%). Within six months of entering the index, new fallen angel bond prices tend to recover and usually go back to where they were six months before entering the index.
   

   Source: VanEck.

   FEATURED PRODUCT VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL US) – Tracks the ICE US Fallen Angel High Yield 10% Constrained Index providing access to fallen angel bonds denominated in US dollars and issued in the US market. – Houses $2.8bn in AUM; comes with an expense ratio of 0.35%.

2. Contrarian sector approach: The recovery of the energy sector helps demonstrate this. Fallen angels’ overweight to energy has contributed 1.57% to outperformance this year versus the High Yield Broad Market Index and has returned 42.57% since 31 March, 2020.
3. Higher relative credit quality: New fallen angels have been rated BB, increasing the index’s BB exposure to 92.78% vs 56.58% in the broad high yield market. Accordingly, this year’s outperformance thus far is coming from the BB allocation, which has contributed to more than 100% of its return while other credit quality allocations have detracted performance.

Kraft, Ford and the new energy fallen angels have averaged a 19.36% price return since index entry. The average of all 2020 fallen angels is about 12%, which is above the historical average. Kraft, EQT and EQM were helped even more as the Federal Reserve announced an expansion of the Corporate Credit Facilities on April 9, a few days after they entered the index. Ford has had more support from the Fed, as they bought some of its bonds as part of their program to support liquidity. However, EQT bonds are the top performers (based on price return) since index entry in March 2020 with a 31.20% price appreciation.

Source: VanEck.

Alpha potential despite tighter yields

Yields and spreads have tightened significantly from the elevated levels at the end of March. Nevertheless, we believe new fallen angels may provide high yield investors with outperformance versus the broader high yield market due to the significant price returns driven by buying deeply discounted bonds. In our view, a fallen angel high yield strategy performs best in an environment like the current one, characterized by the high volume of fallen angels. Given our outlook for an additional $100 to $150 billion of new fallen angels this year, we do not believe that the current cycle or the potential to outperform has run its course.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)