Simply looking at past performance, it’s easy to conclude that the iShares Fallen Angels ETF (FALN) and the VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL) are the cream of the junk-bond ETF crop. And a deeper look at how these funds are constructed helps explain why these funds should continue to deliver superior risk-adjusted gains in the years ahead.
The phrase “fallen angels” refers to investment grade bonds that have been subject to a ratings agency downgrade. Bond traders tend to unload such bonds as underlying fundamentals deteriorate—in advance of an actual downgrade. They know that an eventual downgrade could be imminent, which often triggers a sell-off from funds that can’t hold sub-investment grade bonds.
By the time such a downgrade hits the newswires, these bonds have often become quite oversold by falling, on average, seven percent in the six months prior to the downgrade, according to Fran Rodilosso, head of fixed-income ETF portfolio investment at VanEck. “A great deal of risk will have been priced in by the time such bonds are classified as fallen angels,” he notes.
And that’s where the phrase “only fools rush in where angels fear to tread” comes to mind. By focusing on the highest-quality bonds, as these funds do, these bond buyers are actually not quite so foolish. Across various economic and interest rate cycles, higher-quality junk bonds have outperformed their lesser quality peers.
These types of bonds are tracked both by the BofA Merrill Lynch US Fallen Angel High Yield Index, which underpins the VanEck fund, and the Bloomberg Barclays US High Yield Fallen Angel 3% Capped Index that is the foundation of the iShares fund. And both indexes have built relatively impressive track records.
For example, the BofA Fallen Angel index has delivered a 270 percent gain since the end of 2003, twice the performance of the Morningstar high-yield bond average.
Better credit quality explains part of the outperformance. Roughly 77 percent of the bonds in the BofA index are classified as BB or better. In contrast, less than half of the bonds in general high-yield bond funds meet that ratings threshold, according to VanEck.
The “rebound effect” also explains some of the gains. As noted, bonds tend to sell off sharply before they are downgraded to junk status. Yet in the subsequent six months after the downgrade, such bonds tend to erase all of those losses. In effect, the fallen angel indexes which underpin these ETFs tend to almost perfectly time the bottom of the market for these bonds.
NYU professor Edward Altman has studied the high-yield market for roughly two decades and has found that fallen angel bonds tend to have lower default rates than original issue high-yield bonds. For example, roughly 3.5 percent of fallen angel bonds have defaulted each year, on average, over the past two decades compared to 4.5 percent of original issue bonds.
Still, the folks at BlackRock’s iShares unit make an important distinction. “Relative to investment grade bonds, high-yield bonds do portend a higher degree of default risk, so it’s important that investors consider these investments in the context of their risk tolerance,” a BlackRock spokesperson said in an email response.