Massively higher returns on offer in ‘fallen angel’ bonds
The global pandemic has thrown up major opportunities for investors in the bonds of ‘fallen angel’ companies which have been downgraded from investment grade to high yield, a leading global investor says.
David Newman, chief investment officer and head of global yield at Allianz Global Investors, told Investment Magazine’s Fiduciary Investors Digital Symposium that history shows that while returns from fall angels correlate with investment grade and high yield, the net returns are “massively higher”.
“The dislocation from COVID-19 could potentially lead to a continuation of the red line [significantly higher returns]” from fallen angels.
Newman said that after a reprieve in the past year and a half, COVID-19 has triggered a wave of downgrades from BBB to BB, with some US$220 billion worth of downgrades already.
Some US$900 billion of fallen angels could come in this downgrade cycle, or 45 per cent of the whole high yield market.
That has triggered price dislocation with the new crop of fallen angels trading at around 200 basis points wider than similarly rated names which were BB originally.
The investment chief said that this is creating opportunities for investors to exploit the price dislocation and take a short-term position in bonds that are cheaper than credit fundamentals suggest, and then sell when they approach fair value.
According to Newman, past recessions such as the global financial crisis shows that if you invest during the recession, fallen angels outperform the high yield market and the equity market, based on 12-month forward returns,
Two factors provide an opportunity for investors to earn returns from fallen angels that are above standard BB returns, added.
“One is buying when that dislocation is there at the front end, which gives you a lot of extra return; but also, by having better upgrade characteristics at the end.”
After the downgrade, special situation funds try to determine if a company is a ‘fallen knife’ or ‘fallen angel’. “If a fallen angel, it starts to become normalised,” he says.
But timing is crucial, with most of the performance coming in the first three months.
AllianzGI looked at the cohort of all downgrades from 1998 to 2019. “What we found is fallen angels were not more significantly likely to default, but they are more significantly likely to be upgraded.”
Newman said that fallen angels are typically businesses downgraded because of a cyclical downtown when the economy slows, and not a structural downturn where products have become irrelevant, like the Yellow Pages.
With fallen angels more likely to become investment grade than non-fallen angels, that also creates longer-term opportunities, Newman stated.
A key to the fallen angels’ strategy is active security selection to avoid ‘falling knives’ that progress straight to distress.
“If you get it wrong and these businesses aren’t going to survive, these are fallen knives and they may never return and could default.”
Newman also said that central bank support is helping with liquidity, not insolvency. “Some of the opportunity has been taken away, but not all of it.”