Asian professional investors are increasingly shifting their fixed income asset allocation from investment-grade (IG) to “fallen angel” bonds, a sub-asset class that previously attracted little attention because of liquidity concerns, to diversify away from IG and slightly increase their risk exposure.
“Fallen angel” bonds are IG bonds (typically rated BBB) that have been downgraded to junk bonds (typically BB), which are debt securities rated poorly by credit agencies in the wake of a deterioration in the financial status of the issuer.
However, “fallen angels” have historically offered equity-like returns at bond-like risk, which means they present lower risk to investors than equities, which are traditionally considered high-risk, high-return investments.
These securities have delivered returns of 8.2% so far this year, which is very close to the 8.3% delivered by high yield (HY) bonds, and much higher than the 3% to 5% returns on IG bonds, and 5% return on equities.
For Asian investors, there is increasing interest in the income-generating aspect of “fallen angels” as an asset class, compared to IG bonds, HY bonds, and equities. These investors are professional investors, including institutional and high-net-worth clients.
“What we're seeing is that our Asian clients, in general, are opportunity-driven and they have a strong ability to appreciate that risk-return asymmetrical profile that’s existing because of an inefficient market structure,” says Paul Benson, head of efficient beta, insight investment, at BNY Mellon Investment Management. “They’re thinking about that as almost like an arbitrage opportunity, as opposed to our North American investors, and our European investors to some degree, who are more focused on the overall large-scale asset allocation plan.”
There are a couple of reasons for the renewed interest in “fallen angels”. On the issuer side, the flood of cash that entered the financial markets and the global economy in the wake of quantitative easing after the pandemic set in resulted in upgrades for many issuers. On the investor side, there were few downgrades from IG to junk bonds, hence, there were fewer “fallen angels” to invest in.
Secondly, the quantitative tightening undertaken by central banks to control inflation post-Covid resulted in soaring interest rates that presented business difficulties and challenges for many issuers, thus resulting in downgrades by credit rating agencies.
“Now that we're getting into a more challenging environment, that's actually paradoxically going to be really good for fallen angel investors because we're going to start seeing more downgrades from the Triple-B space as rating agencies get tougher on these companies. That's what the fallen angel investors needs to see. They need to see more supply coming in so they can come in at that discount, harvest that opportunity set, and drive that alpha above and beyond broad high yield,” Benson says.
The risk that comes with investing in “fallen angels” is that there may be a sudden, large increase in interest rates in the coming months. The other is default risk on the part of specific issuers.
“We saw that when rates went from zero to 5%. That certainly was a very painful experience for all risk asset classes, including high yield, fallen angels, including IG. But we don't know anybody, really, who thinks that rates are going to go from 4.5% to 9%. On the default risk, we saw that default risk for this asset class has been around 1.5% (which is very low),” Benson explains.