Yield Curve Strikes Present One other Tailwind for Fallen Angels

By Nicolas Fonseca, CFA, Affiliate PM

Fallen angel excessive yield bonds¹ have continued to outperform broad excessive yield² in a wide range of market circumstances. In Q2 2021, fallen angels’ longer period contributed to their 1.87% outperformance over the broad excessive yield bond market. The phase additionally benefitted from greater weights to latest fallen angels and going ahead we count on credit score scores upgrades to more and more contribute to outperformance.

The yield curve flattened following the much-anticipated June Federal Reserve (Fed) assembly. Quick-term charges rose whereas long-term yields declined because of the weaker outlook for longer-term progress, as traders count on the Fed to behave shortly if inflation is just not transitory. As we talked about beforehand³, adverse returns are usually not a given for fallen angel excessive yield bonds when charges rise. It hasn’t been the case thus far this yr, because the 10-Yr Treasury rose by 81bps throughout Q1 2021, and each the fallen angel and the broad excessive yield indices posted optimistic returns (0.18% vs 0.90%, respectively) as of March 31, 2021.

Q2 2021 was completely different. The 10Y barely moved – and truly fell to 1.45% on 6/30/2021 from 1.74% on 3/31/2021 – giving a lift to longer-term bonds. The fallen angel index has the next period than the broad excessive yield market, because of the normal longer maturity of funding grade issuance. Consequently, the flattening of the curve⁴ has supplied a bonus to fallen angels, which are actually on high of the broad excessive yield market by 1.13% YTD as of 6/30/2021 and 1.87% in Q2 2021, after outperforming by 67bps in April, 3bps in Might and 113bps in June. For Q2 2021, fallen angels returned 4.64% vs 2.77% for the broad excessive yield market and have returned 4.83% this yr by way of 6/30/2021.

Treasury Yield Curve Charges

Supply: U.S. Treasury.
The CMT yield values are learn from the yield curve at mounted maturities, presently 1, 2, Three and 6 months and 1, 2, 3, 5, 7, 10, 20, and 30 years. This technique offers a yield for a 10 yr maturity, for instance, even when no excellent safety has precisely 10 years remaining to maturity.

Fallen Angel Bonds vs. Broad Excessive Yield and 10Y

Supply: ICE Knowledge Providers, US Treasury.

Fallen Angel Unconstrained Strategy

The outperformance by fallen angels over broad excessive yield in Q2 2021got here largely from the newer fallen angels⁵ that drove efficiency final yr. The unconstrained sector strategy of the fallen angel index offers differentiated publicity, notably to the potential restoration of crushed down sectors. The upper allocation to power (near 30% since Might 2020) is a transparent instance of this contrarian view—one which has been paying off as WTI crude oil has jumped from the excessive $40s in the beginning of the yr to mid/lows $70s, serving to power corporations enhance their steadiness sheets.

Supply: FactSet, VanEck

The upper issuer allocation (capped at 10%) additionally added to efficiency. Among the many high 10 contributors for Q2 2021, eight had entered throughout the wave of downgrades final yr, together with the three greatest fallen angels: Occidental Petroleum, Kraft Heinz and Ford.

Supply: FactSet, VanEck

Many of those issuers have mentioned in latest calls their objectives to return to funding grade.

• Oxy’s Rob Peterson, Senior VP & CFO, throughout their 2021 Q1 name: “On previous calls, I’ve highlighted our choice for a viable path to return to investment-grade credit standing…We’re not there at the moment, however we imagine this aim is achievable”.
• Ford’s John T. Lawler, CFO, throughout their Capital Markets Day: “Every part we have now talked about at the moment and are doing is constructed on disciplined capital allocation, making the fitting decisions to create worth for our prospects and our traders…we’re optimizing our capital construction with an goal to return to funding grade scores”.
• APA’s Steve Riney, Government VP and CFO, throughout their 2021 Q1 name: ”You need to perceive, nevertheless, that our extra related goal is to return to investment-grade credit score standing. To that finish, we’ll proceed to funds conservatively, concentrate on prices, free money circulate technology and debt discount and keep shut contact with the score businesses to make sure that we’re taking the suitable steps to attain that aim in a well timed method”.
• Western Midstream’s Michael P. Ure, President and CEO, throughout their 2021 Q1 name: “We keep a really energetic dialog with score businesses, meet with them on a really common foundation. We really feel as if we’re at funding grade, from a metric standpoint as we sit right here at the moment. And so our focus is on ensuring that we will proceed to take care of these general metrics in totality. In order that we’re in a possibility to have the ability to transfer out to the investment-grade credit standing scale…So for us, it is nearly sustaining the metrics that we have now at the moment and if and when it comes and we welcome the possibility to get again as much as funding grade”.
• Ovinitiv’s Corey Douglas Code, Government VP & CFO, throughout their 2021 Q1 name: “Over the long run, we’ll proceed to steward our enterprise to a leverage ratio of 1.5 occasions web debt-to-EBITDA or much less at mid-cycle costs. We expect this degree of leverage is suitable for an E&P firm and in line with an investment-grade credit standing. The credit standing businesses have taken discover of the robust outlook for our enterprise and the acceleration of our debt discount efforts. As such, we have now lately obtained optimistic credit standing outlook modifications from the entire score businesses.”

Some promote aspect outlets have lately talked about that the worldwide financial system recovering, greater company earnings and sturdy capital markets might assist a few of these issuers change into rising stars within the coming months. JPMorgan estimates that there are roughly $57B {dollars}’ price of BB-rated bonds which might be one score company motion away from regaining funding grade standing.

The chart under presents a fast reminder of how rising stars have traditionally carried out relative to the broad excessive yield market.

Fallen Angel Bonds Common Value Returns Previous to Credit score Ranking Upgrades

Supply: ICE Knowledge Providers, VanEck. Knowledge as of 6/30/2021.

The yield to worst of fallen angels began the yr at 3.80, rose to three.91 on the finish of Q1 however has been falling since then. Presently, the yield is 3.35. Length for fallen angels has been comparatively flat all yr, barely shifting from 6.82 in the beginning of the yr to six.81 on the finish of the primary half. In the meantime, broad excessive yield has seen some extension by about 0.Three thus far. Fallen angels’ longer period contributed to their 1.87% outperformance vs. the broad excessive yield market as 60% of that determine got here from yield curve actions.

Supply: ICE Knowledge Providers, VanEck

New Fallen Angels

Two fallen angel bonds joined the index in Q2, including roughly $0.6B of debt for a complete of $2.7B for the primary half of 2021. We count on to see little to no exercise on the downgrade cycle as a number of elements—such because the financial system reopening, excessive vaccination charges, steadiness sheet repairs and low rates of interest—have created a benign credit score surroundings. Excessive yield issuers have continued to reap the benefits of decrease funding value to refinance a few of their present debt. The scores businesses are actually anticipating decrease default charges due to optimistic market circumstances and higher financial outlook, translating into fewer downgrades general.

Supply: ICE Knowledge Providers, VanEck

Rising Stars

Only one rising star emerged in Q2. Nonetheless, as talked about, there are a variety of potential candidates for upgrades to funding grade standing. We count on extra upgrades than downgrades going ahead, because the COVID-19 mud settles and the financial system retains up its robust tempo of progress. Proudly owning among the potential rising stars has traditionally supplied outperformance as credit score upgrades have adopted a restoration in costs.

Supply: ICE Knowledge Providers, VanEck

Q2 2021 Efficiency by Sector

There have been no important modifications within the sector weightings for fallen angels all through Q2. Power retains the highest spot when it comes to weight and returns for the quarter, however its worth is on the decrease finish, doubtlessly leaving extra room to run, particularly if crude oil retains going up. Client Items positioned second behind power (when it comes to contribution to efficiency) as client demand has been excessive.

Supply: ICE Knowledge Providers, VanEck

Q2 2021 Efficiency by Ranking

Fallen angels proceed to tilt closely in direction of the very best scores inside excessive yield, with 94% being rated double-BB. Decrease rated bonds carried out the very best over Q2 with CC-rated bonds returning nearly 50% as traders maintain looking for yield and have been prepared to take further danger to seek out it. With low default outlooks throughout the business, being on the decrease scores might repay, however you will need to be aware that the ICE BofA CCC & Decrease US Excessive Yield Index ended the quarter with an OAS⁶ of 583, the bottom degree in over a decade.

Supply: ICE Knowledge Providers, VanEck

Initially printed by VanEck, 7/19/21

DISCLOSURES

¹ Fallen angel excessive yield bonds are represented by the ICE US Fallen Angel Excessive Yield 10% Constrained Index (H0CF).

² Broad excessive yield (HY) is represented by the ICE BofAML US Excessive Yield Index (H0A0), additionally referred because the broad benchmark.

³ Supply: VanEck

⁴ Flattening the (yield) curve is when short-term and long-terms bonds are approaching the identical see charges.

⁵ FactSet. Contribution to outperformance represents the chance value of an funding supervisor’s funding choices relative to the general benchmark. It’s calculated by summing the three elements: allocation, safety and interplay results.

⁶ OAS: The Choice-adjusted unfold is the measurement of the unfold of a fixed-income safety charge and the risk-free charge of return, which is then adjusted to keep in mind an embedded possibility.

VanEck assumes no legal responsibility for the content material of any linked third-party web site, and/or content material hosted on exterior websites.

A fallen angel bond is a bond that was initially given an investment-grade score however has since been decreased to junk bond standing.

Excessive yield bonds could also be topic to better danger of lack of earnings and principal and are prone to be extra delicate to hostile financial modifications than greater rated securities.

Please be aware that VanEck might provide investments merchandise that spend money on the asset class(es) included herein.

This content material is printed in america for residents of specified international locations. Traders are topic to securities and tax laws inside their relevant jurisdictions that aren’t addressed on this content material. Nothing on this content material ought to be thought of a solicitation to purchase or a suggestion to promote shares of any funding in any jurisdiction the place the provide or solicitation could be illegal beneath the securities legal guidelines of such jurisdiction, neither is it meant as funding, tax, monetary, or authorized recommendation. Traders ought to search such skilled recommendation for his or her explicit state of affairs and jurisdiction.

The knowledge herein represents the opinion of the writer(s), however not essentially these of VanEck, and these opinions might change at any time and every now and then. Sure statements contained herein might represent projections, forecasts and different ahead wanting statements, which don’t mirror precise outcomes, are legitimate as of the date of this communication and topic to alter with out discover. Data supplied by third social gathering sources are believed to be dependable and haven’t been independently verified for accuracy or completeness and can’t be assured. Any dialogue of particular securities/monetary devices talked about within the commentary is neither a suggestion to promote nor a advice to purchase these securities. Historic efficiency is just not indicative of future outcomes. Present knowledge might differ from knowledge quoted. Any graphs proven herein are for illustrative functions solely.

ICE BofAML US Excessive Yield Index (H0A0, “Broad HY Index”), previously referred to as BofA Merrill Lynch US Excessive Yield Index previous to 10/23/2017, is comprised of below-investment grade company bonds (based mostly on a median of assorted score businesses) denominated in U.S. {dollars}.

ICE US Fallen Angel Excessive Yield 10% Constrained Index (H0CF, Index) is a subset of the ICE BofA US Excessive Yield Index and contains securities that have been rated funding grade at time of issuance.

ICE BofA CCC & Decrease US Excessive Yield Index tracks the efficiency of U.S. greenback denominated company debt publicly issued within the U.S. home market with a given funding grade score CCC or under.

ICE Knowledge Indices, LLC and its associates (“ICE Knowledge”) indices and associated data, the title “ICE Knowledge”, and associated emblems, are mental property licensed from ICE Knowledge, and will not be copied, used, or distributed with out ICE Knowledge’s prior written approval. The licensee’s merchandise haven’t been handed on as to their legality or suitability, and are usually not regulated, issued, endorsed, offered, assured, or promoted by ICE Knowledge. ICE Knowledge MAKES NO WARRANTIES AND BEARS NO LIABILITY WITH RESPECT TO THE INDICES, ANY RELATED INFORMATION, ITS TRADEMARKS, OR THE PRODUCT(S) (INCLUDING WITHOUT LIMITATION, THEIR QUALITY, ACCURACY, SUITABILITY AND/OR COMPLETENESS).

All investing is topic to danger, together with the attainable lack of the cash you make investments. Bonds and bond funds will lower in worth as rates of interest rise. As with every funding technique, there is no such thing as a assure that funding aims will probably be met and traders might lose cash. Diversification doesn’t guarantee a revenue or defend towards a loss in a declining market. Previous efficiency is not any assure of future outcomes.

Learn extra on ETFtrends.com.

The views and opinions expressed herein are the views and opinions of the writer and don’t essentially mirror these of Nasdaq, Inc.