Key Takeaways
- Investment-grade bond downgraded to junk status.
- Higher yields but increased default risk.
- Forced selling causes sharp price declines.
- Potential recovery if issuer stabilizes.
What is Fallen Angel?
A fallen angel is a bond that was originally issued with an investment-grade credit rating but has been downgraded to junk or high-yield status due to the issuer's worsening financial condition. This downgrade typically occurs when a rating agency lowers the bond's status from BBB- or higher to BB+ or lower, reflecting increased credit risk and reduced investor confidence.
Understanding fallen angels is essential because they represent a unique segment of the bond market that offers higher yields but carries elevated default risks compared to traditional investment-grade bonds. Investors often compare fallen angels to concepts like bad credit to evaluate risk.
Key Characteristics
Fallen angels have distinct features that differentiate them from original junk bonds and other fixed-income securities:
- Initial Rating: Issued as investment-grade bonds, usually rated BBB- or higher, before downgrade.
- Credit Rating Shift: Downgraded to high-yield status, generally BB+ or lower, marking the transition to fallen angel status.
- Yield Profile: Offer higher yields than comparable investment-grade bonds to compensate for increased default risk.
- Default Risk: Average 12-month default rates for fallen angels (around 3.51%) tend to be lower than those of original junk bonds.
- Potential Recovery: Some fallen angels may regain investment-grade status, becoming "rising stars," which can enhance returns.
- Market Impact: Downgrades often trigger forced selling by funds restricted to investment-grade bonds.
How It Works
When a bond issuer experiences financial distress—such as declining revenues, higher debt loads, or operational challenges—credit rating agencies may downgrade their bonds. This downgrade from investment-grade to junk status transforms the bond into a fallen angel, increasing its yield to attract investors willing to accept higher risk.
Institutional investors with mandates restricting junk holdings are often forced to sell fallen angels, causing price volatility. However, those who can tolerate this risk may benefit from the bond’s recovery potential if the issuer stabilizes. For instance, monitoring earnings reports can provide insights into whether a company is improving its financial health, influencing the bond’s outlook.
Examples and Use Cases
Fallen angels commonly appear in sectors vulnerable to economic cycles or industry disruptions. Here are some notable examples:
- Airlines: Companies like Delta and American Airlines experienced downgrades during economic downturns, turning some bonds into fallen angels.
- Energy Firms: Volatile commodity prices have caused some energy companies to experience fallen angel status amid financial strain.
- Bond Funds: Specialized funds such as those tracking best bond ETFs may include fallen angels to capture higher yields within diversified portfolios.
- Fixed Income Benchmarks: Indices like those tracking the Bloomberg U.S. High Yield Fallen Angel 3% segment provide opportunities for investors to target this niche.
Important Considerations
Investing in fallen angels requires careful assessment of credit risk and market conditions. While higher yields can be attractive, the potential for default remains significant, and liquidity may be lower compared to investment-grade bonds.
It's important to balance the risk-reward profile by considering factors such as the issuer’s debt levels, industry trends, and broader economic indicators like the federal funds rate, which influences borrowing costs and credit markets. Diversifying across bonds, including those like BND, can help manage risk exposure in a fixed income portfolio.
Final Words
Fallen angels offer higher yields with a distinct risk profile, reflecting their downgrade from investment-grade to high-yield status. Evaluate your risk tolerance carefully and consider consulting a financial advisor to determine if these bonds fit your portfolio strategy.
Frequently Asked Questions
A fallen angel bond is a bond that was originally rated as investment-grade but has been downgraded to junk or high-yield status due to worsening financial health of the issuer. This typically happens when credit ratings fall from BBB- or higher to BB+ or lower.
Fallen angels start as higher-quality investment-grade bonds and are later downgraded, often retaining better credit profiles and lower default rates than original junk bonds, which begin as high-yield securities from issuance.
Downgrades that create fallen angels can result from financial distress like falling revenues or rising debt, external factors such as economic downturns or industry slumps, and issuer-specific issues like management problems or legal troubles.
Many institutional investors are mandated to hold only investment-grade bonds, so downgrades force them to sell fallen angels, causing sharp price declines and increased market volatility.
They offer higher yields than comparable securities and potential price recovery if the issuer improves financially, making them attractive for investors seeking value and willing to accept elevated default and liquidity risks.
Fallen angels carry higher default risk than investment-grade bonds, with an average 12-month default rate around 3.51%, and can be less liquid and more volatile, especially during market downturns or issuer distress.
Yes, if the issuer's financial health improves, fallen angels can be upgraded back to investment-grade status and are sometimes called 'rising stars' when this happens.
During the COVID-19 crisis, sectors like airlines and energy saw many fallen angels due to severe industry challenges, leading to significant price drops but also potential recovery opportunities for investors who managed the risks well.
