The iShares Fallen Angels USD Bond ETF (NASDAQ:FALN) invests in corporate bonds that have been downgraded by credit rating agencies to below investment grade. The attractiveness of this segment is based on the idea that bonds will sell in anticipation of downgrades beyond their underlying fundamentals, resulting in potentially attractive relative value among “fallen angels” who can outperform going forward.
That being said, it has been a painful year for the bond market amid rising interest rates and macroeconomic concerns. The FALN ETF is down 12% year-to-date, underperforming high yield bonds in general and we still see downside risks. The key here is to monitor credit spreads that have otherwise been resilient but could widen in deteriorating economic conditions. With this move, we are maintaining a cautious approach to high yield corporate bonds and fallen angels, expecting heightened volatility.
What is the FALN ETF?
The FALN ETF tracks the Bloomberg US High Yield Fallen Angel 3% Capped Index. According to methodology, bonds whose credit rating has been downgraded to below investment grade ((Ba1/BB+ or lower)) by at least one of the major rating agencies, may be included in a monthly rebalancing. Individual corporate issuers are limited to a 3% weighting within the index and ETF. Other inclusion criteria include a minimum of one year to maturity as well as a nominal issue value of at least $150 million.
There are academic research suggesting that bond market fallen angels offer higher long-term risk-adjusted returns, outperforming after their downgrade. This is evident when comparing FALN’s performance with the iShares iBoxx $ High Yield Corporate Bond (HYG) ETF which is a benchmark for high yield bonds. Since the inception date of the FALN fund in 2016, the fund has generated a cumulative return of 43%, compared to 24% for HYG. Historical index data going back several decades confirms this momentum, outperforming over the past decade.
One explanation is a noted “fallen angel technical effect” where some investors are compelled to sell lower quality bonds based on their strategic mandate. This forced sale can decouple the price of bonds from their actual financial condition and credit metrics. The potential for Fallen Angels price appreciation can be attributed to bonds being oversold as they are downgraded only to recover as their credit conditions stabilize. Data from iShares shows that within six months of entering the index, prices of fallen angel bonds tend to recover to levels six months before entering the index.
Second, the bonds of fallen angels can also represent a contrary view. By the time a sector’s bonds are downgraded, usually based on financial data and historical earnings, the market may already be looking at recovery.
Finally, there is also the aspect that fallen angels offer relatively higher credit quality compared to other junk bonds. Since fallen angels began in investment grade, these bonds have on average come from a structurally stronger position compared to originally issued high yield bonds.
The flow FALN Wallet is made up of 291 bonds, including several issues from the same company. Companies in the energy sector represent the largest sector weighting at 22% in the portfolio. Bonds from companies like Occidental Petroleum (OXY) and Apache Corporation (APA) are notable fallen angels, earning a downgrade in 2020 at the onset of the pandemic oil crash.
Exposure to the energy sector is attractive as it has outperformed on the back of rising oil and gas prices, helping to support credit conditions within the sector. On the other hand, the environment is worse for the rest of the portfolio, including a 19% weighting in consumer cyclical bonds which are currently under pressure from high inflation and fears of a slowing growth that add questions to future prospects.
In terms of credit quality, over 86% of the fund is in “BB rated” bonds, or equivalent, which is the first level below investment grade. Finally, we also noted that the maturity profile is biased towards the short to medium term with more than 60% of bonds maturing in less than seven years with an effective duration of 5.6 years. This means that the FALN has a medium sensitivity to changes in market interest rates.
The fund pays a variable monthly distribution based on the portfolio’s underlying income and the corporate coupon payment schedule. The current twelve-month yield is quoted at 3.9% although the 30 day SEC yield which normalizes to the most recent payments suggests a higher return close to 5%.
Despite data showing that FALN has historically outperformed other segments of the bond market, 2022 has so far been an exception. FALN is down 12% against a 9% decline in HYG as a proxy for the high yield bond market.
The first point to consider is the trend in market interest rates, which have risen sharply this year across the entire maturity curve. Persistently high inflation surprised on the upside, forcing the Fed to tighten credit conditions as a major development. Beyond the two recent Fed rate hikes, Treasuries have moved to a decade high, including the 10-year bond yield currently at 3%. Naturally, as interest rates rise, bond prices fall, which largely explains the weakness in corporate bonds this year.
The other component of bond prices is the change in credit spreads which reflects the additional risk beyond treasury bills. While spreads have risen from 2021 lows, conditions are still strong, even among high yielders and given low inequality. At this point, the direction credit spreads take from here will have significant implications for the future outlook for the FALN ETF and high yield bonds, which we will discuss in more detail below. The takeaway here is that the liquidation of high yield companies and the FALN ETF this year has so far been broadly controlled.
It should also be noted that FALN shares a similar strategy and exposure to the VanEck Fallen Angel High Yield Bond ETF (ANGL). Although the actual underlying tracking indices are different, the two ETFs have a very similar performance history with a slight advantage over the FALN with a return of 13.4% over the last 3 years, compared to 12.6% for ENGL. FALN is our pick being both based on a slightly lower expense ratio of 0.25% compared to 0.35% in ANGL. FALN is also a larger fund with $3.4 billion in assets under management, which means it is more liquid for trading purposes.
FALN Price Outlook
The challenge for FALN and high yield bonds is the uncertainty regarding the macroeconomic outlook. As mentioned, the corporate bond market has been relatively stable, supported by the economic momentum in 2021 and strong earnings in recent quarters. Strength in the energy sector, which traditionally plays an important role in high yield, also supported broader credit conditions. This is a double-edged sword, as some names in the energy sector could eventually be reclassified as investment grade and disappear from the index. This would end up hurting the Fallen Angels profile as it would lose its best performers.
The chart below shows the “option-adjusted spread” of the current high-yield index. It’s a indicator tracked by the Fed, which we use as a proxy for junk bond credit terms. A higher spread can be interpreted as the market demanding a higher yield to hold risky bonds above the corresponding risk-free Treasuries. The takeaway is that the current level of 4%, although up from a low of 3% in 2021, remains at a historically tight level. The index has climbed above 8% several times over the past decade and climbed as high as 21% during the last financial crisis.
The point we’re getting at here is that if there is a scenario where the economy tips into a recession that is defined by an increasing number of high yield bond defaults and corporate bankruptcies, we can expect credit spreads to widen significantly from current levels.
Should credit conditions deteriorate materially, the door would be open to even greater losses in high yield bonds and the FALN ETF in the future. In our opinion, it is a mistake to look at the FALN ETF price chart and assume that since it is far from the highs, the bond segment is cheap or undervalued.
On the upside, the bullish case of FALN is going to require a few things to happen. First, stable long-term interest rates or at least a pullback to lower yields will be key for bonds to gain momentum as sentiment improves. At the macro level, we want to see signs that inflation is peaking and hopefully beginning to decline with indications that the economy can continue to grow even if the Fed continues its rate hike cycle.
There’s a lot to like about FALN, which represents a compelling bond investment strategy that has outperformed over the long term. The iShares Fallen Angels USD Bond ETF is a good option for adding diversification to fixed income securities. Regarding the near-term outlook, we view the current environment as high risk for junk bonds which are facing both rising interest rates and credit pressures.