4 passive pitfalls: why fallen-angel bonds need active management

While it may seem appealing to invest in fallen angels¹ through passive vehicles, we believe active management is better suited to the particularities of the segment. Passive strategies fail to ensure adequate credit quality, sufficient liquidity and a deep enough universe in this space, leaving investors open to the risk of further ratings deterioration and its potential costs.

How does our Fallen Angels Recovery strategy address such issues to find the best recovery potential? We explore four key areas.

1. Passive drawback: fails to identify falling knives

Passive strategies invest indiscriminately in all fallen angels, neglecting to distinguish between fallen angels with the greatest potential for either outperformance or underperformance. When a bond is downgraded to high yield, there is always a risk of further credit deterioration. Fallen angels that fall through the rating spectrum into distress/default are known as Falling knives and can result in a significant permanent loss of capital. Simply tracking the fallen-angels index exposes investors to falling knives that detract from potential performance and add to drawdown.

Active advantage: fundamental analysis to assess creditworthiness

Fallen angels fall for a reason: a downgrade to high yield always reflects a specific set of circumstances. Since acute idiosyncratic risks exist in this space, fundamental analysis on a name by name basis is crucial to identifying, and excluding, falling knives to boost the price recovery potential of the portfolio.

Our team of analysts reviews credit quality prior to purchase to identify if a company’s business model and financial profile remain viable, despite the downgrade. We differentiate between downgrades based on a temporary change in a company’s financial profile (perhaps due to a debt-funded acquisition) and downgrades following a deterioration in the company’s business profile. The latter may be temporary and manageable or could be as a result of a long-term, structural deterioration in the business or sector. The analysts review the company’s turnaround plan and the challenges facing the wider sector to assess the likelihood of the Fallen Angel stabilising its credit quality or becoming a Fallen Angel.

We continue to monitor credit quality after purchase to ensure the company is delivering, for instance, on a turnaround strategy or other plans. Continuous monitoring of the company’s outlook means we can keep pace with on-going developments and act swiftly should a fallen angel appear to be turning into a falling knife.

2. Passive drawback: treats all the issuer’s bonds as equal

All fallen angels are regarded as equal by passive approaches, which fail to make a distinction between different bonds from the same issuer. Aspects such as a bond’s liquidity, covenants (including coupon steps), the size of the overall bond issue and when the notes were launched are all characteristics where investing indiscriminately means potentially missing opportunities or incurring costs.

Active advantage: discerns between bonds for potential

Our credit analysis aims to identify the bonds with the strongest performance potential within the company’s debt structure. For instance, some notes may have coupon step-up clauses which is not reflected in the price, better covenants, be larger in size or have been issued more recently and therefore more liquid. Our analysts look to narrow down our selection to more liquid – or easily traded – issues or suggest alternative notes with relatively superior yields².

How does our Fallen Angels Recovery strategy use active management to address the drawbacks of a passive strategy? Watch our video.

3. Passive drawback: limits investment to the index

A Fallen Angel is a high yield bond that was initially investment grade at launch. A bond issued by a high yield issuer that was previously investment grade is not a Fallen Angel and is not included in the Fallen Angel index despite having the same characteristics (Assuming no change in bond documentation). Therefore a  passive fallen-angels portfolio tends to become more illiquid over time as a result of fallen angels ageing and newer issues from previously downgraded companies not being included in the index. This constrains the investable universe and limits opportunities to invest.

Active advantage: broadens the universe

We take several steps to deepen the fallen angels universe beyond the index and capture the best prospects. For instance, to extend the universe we invest in bonds issued by fallen-angel issuers after they have been downgraded, provided the notes:

• Share the same characteristics as the downgraded bond that is part of the fallen angels index
• Are easier to obtain and potentially more liquid, with smaller bid-offer spreads
• Are part of emerging markets (EM) and satisfy our criteria that the bond should behave like a fallen angel rather than a falling knife.

For instance, a Czech real estate company was downgraded last year to BB+ but, as an EM issue, was not a constituent of the fallen-angel index. We have followed the name and sector closely for a number of years and believe the borrower should be able to operate as a BB entity going forward.

4. Passive drawback: a lack of alpha potential

Since passive strategies invest in all fallen angels in the index according to their weighting, they do not identify the ample opportunities in this space to generate excess return potential.

Active advantage: tilts, value selection and cost savings

Alpha generation is prioritised in our strategy by:

• Systematically overweighting new fallen angels at the time of downgrade. Our research has found that new fallen angels historically outperform old fallen angels because the price overreaction at downgrade generally recovers within two years³
• Traditional bond selection where analysts identify the best potential value issues. Our decades of investing in crossover bonds rated BB to BBB gives us deep experience in the space and we will overweight older Fallen Angels which we believe are on a positive credit trajectory and offer value as well as our preferred names in the native BB (or even BBB) space
• Active management of deteriorating situations. Where we feel the risk of distress or default is increasing but has not yet met the Fallen Angel threshold we may select the lower priced and longer duration bond. As the likelihood of default increases bond prices converge towards recovery levels which generally means the prices of short-dated bonds will fall materially further than longer-dated bonds. Should the company recover we still benefit from the upside price recovery but have minimised the downside impact.

For instance, an IT and consulting company became a fallen angel but we lost faith in the ability of the company to execute its turnaround plan following numerous management changes and exited the higher priced, shorter duration bonds in favour of the lower priced, longer duration bonds. This approached benefitted the fund in comparison to maintaining an index weight at the time and has contributed to the out-performance of the fund compared to the fallen-angel index  

Pairing quantitative and fundamental approaches

The idiosyncrasies of fallen angels necessitates an active method combining quantitative and fundamental approaches to heighten alpha potential, in our view.

Sectors and names in crisis can prove difficult to trade in times of stress, and decisions can be affected by behavioural biases. That’s why we base our systematic and quantitative approach on rigorous empirical research conducted over two decades – this research gives us material comfort that sectors in crisis typically recover, as do downgraded bonds.

Quantitative tilts – such as overweighting new BB-rated fallen angels in crisis periods – can be combined with a fundamental approach that helps avoid falling knives and generates additional alpha potential in benign periods when the supply of fallen angels is limited.

Our quantamental method is specifically designed for the fallen angels space. We monitor credit quality, improve liquidity, provide a deeper universe, actively tilt towards better value bonds and favour relative value to create a portfolio that targets the best recovery prospects.