There is a corner of the bond market that is often overlooked by investors — and it is currently outperforming. The bonds are known as “fallen angels,” or those that have recently been downgraded to high yield from investment grade. Just two exchange-traded funds invest in the space: iShares Fallen Angels USD Bond ETF (FALN) and VanEck Fallen Angel High Yield Bond ETF (ANGL). The former has a 30-day SEC yield of 7.18%, while the latter carries a 6.87% 30-day SEC yield. Many institutional investors are forced to sell the bonds once they are no longer rated investment grade by the credit rating agencies such as Moody’s and Standard & Poor’s. Therefore, there is an imbalance in supply and demand, which pushes the price down in the short term, explained Zachary Evens, manager research analyst at Morningstar. In fact, a 2019 report from the Chartered Alternative Investment Analyst Association found that bonds that enter the Bloomberg Barclays US High Yield Fallen Angel 3% Capped Index are priced 150 basis points cheaper, on average, than their high-yield peers. That can present an opportunity for investors. “Over time as supply and demand comes back into balance, that gap will close, helping these bonds outperform in that interim time,” Evens said. Tracking outperformance Both FALN and ANG are part of Bank of America’s dynamic prudent yield strategy, which the bank describes as bonds with more exposure to the real economy and less exposure to risks from inflation and interest rates. The strategy has better backtested absolute and risk-adjusted returns, according to Bank of America. This year, the prudent yield sector ETFs as a group have outperformed the U.S. Aggregate Bond Index by 3.5%, on average, and Treasurys by 9.3%, on average, analyst Jared Woodard said in a note Monday. Fallen angels, specifically, are 3.2% above the 10-month moving average, he said. FALN 1Y mountain iShares Fallen Angels USD Bond ETF one-year performance The iShares Fallen Angels USD Bond ETF and VanEck Fallen Angel High Yield Bond ETF track two different indexes. ANGL seeks to replicate the ICE US Fallen Angel High Yield 10% Constrained Index, while FALN tracks the Bloomberg Barclays U.S. High Yield Fallen Angel 3% Capped Index. “[FALN] has traditionally outperformed high yield and investment grade over time,” said Stephen Laipply, global co-head of iShares fixed income ETFs at BlackRock. Historical data shows that the Bloomberg Barclays U.S. High Yield Fallen Angel 3% Capped Index has annualized returns over the past 10 years of 7.25%, as of March 31, according to BlackRock. In comparison, the Bloomberg U.S. High Yield Index has a 4.64% annualized return over the past 10 years, the firm said. Investment grade bonds, as represented by the Bloomberg U.S. Corporate Bond Index, have a 2.85% 10-year annualized return. Be aware of risks Fallen angel portfolios are generally much higher quality than their high-yield peers, said Morningstar’s Evens. About 70% of the bonds are rated just below investment grade at BB. In the high-yield category, about 45% of bonds are rated BB, he said. However, there can be a risk of further credit downgrades, Laipply said. “If they were downgraded initially, there could be some fundamentals with the company that can continue to deteriorate,” he said. Conversely, about 25% of fallen angels over time return to investment grade, Laipply noted. These bonds also typically have a longer duration than their high-yield counterparts, which means there could be interest rate risk. FALN currently has a 4.88-year duration, while iShares Broad USD High Yield Corporate Bond ETF (USHY) has an effective duration of 3.33 years, as of March 31. That said, duration and quality do not matter as much to overall performance and risk, said Evens. Instead, market dynamics and the short-term price collapse and subsequent appreciation are what really affect overall fund performance in this category, he added. “Historically, that has translated to a pretty volatile performance despite the higher credit quality than high-yield peers,” Evens said, noting that the volatility leans more toward a low-volatility equity fund than a core-bond fund. “If you are comparing it to other bond funds, it is certainly a lot riskier and will probably give investors some unwanted surprises during market corrections,” he added. For instance, in 2020, fallen angel funds fell further than core bond funds and even the broad high-yield category, Evens said. Therefore, he suggests a small allocation to fallen angels to help provide a little juice to your portfolio, rather than a sizable one.
