Accumulated fallen angel

What Is a Fallen Angel?

A fallen angel, in the context of fixed income markets, is a bond that was initially issued with an Investment Grade Credit Rating but has since been downgraded to speculative-grade status, commonly known as a High Yield Bond. This reclassification typically occurs when the issuer's financial health deteriorates, increasing the perceived Credit Risk and likelihood of Financial Distress. Fallen angels represent a sub-category within the broader Bond Market that presents unique characteristics and investment considerations for market participants. These downgrades are typically enacted by major rating agencies such as Standard & Poor's, Moody's, and Fitch.¹⁹

History and Origin

The concept of fallen angels emerged alongside the development of the modern credit rating industry. As rating agencies began to assess and assign creditworthiness to corporate and sovereign debt, the possibility of a downgrade from investment grade to speculative grade became a defined event. While such downgrades have always been a part of the credit cycle, notable periods of economic stress, such as the early 2000s recession, the 2008 Global Financial Crisis, and the COVID-19 pandemic in 2020, have seen significant waves of fallen angels. For instance, in 2002, the volume of fallen angel debt issues significantly exceeded that of new speculative-grade issues.¹⁸ During the COVID-19 pandemic, the volume of prospective fallen angels' debt that was downgraded in just the first few weeks of 2020 was five times larger than during the entire Global Financial Crisis, impacting industries such as energy, transportation, and retail.¹⁷,¹⁶ This phenomenon gained increased attention as investors sought to understand the implications for their portfolios and the broader credit landscape.

Key Takeaways

• A fallen angel is an Investment Grade bond that has been downgraded to High Yield Bond status.
• The downgrade is driven by a deterioration in the issuer's financial condition, leading to higher Credit Risk.
• Fallen angels often experience significant price declines around the time of their downgrade, creating potential opportunities for certain investors.
• These bonds tend to have a higher average credit quality than other original-issue high-yield bonds, with a lower historical Default Rate.¹⁵,¹⁴
• Forced selling by institutional investors restricted to holding investment-grade debt can exacerbate initial price drops.

Formula and Calculation

The classification of a bond as a fallen angel is not determined by a specific formula but rather by a change in its Credit Rating from one of the major rating agencies. A bond's credit rating reflects the agency's assessment of the issuer's ability and willingness to meet its financial obligations.

For example, Standard & Poor's assigns ratings from AAA (highest) down to D (in default). An investment-grade rating is typically BBB- or higher. A downgrade below BBB- (e.g., to BB+ or lower) would classify the bond as speculative-grade, thus making it a fallen angel. Similarly, Moody's uses a scale where Baa3 or higher is investment grade, and Ba1 or lower is speculative grade.¹³

While there isn't a formula to "calculate" a fallen angel, investors and analysts assess various financial metrics to anticipate potential downgrades:

• Debt-to-EBITDA Ratio: This measures a company's ability to pay off its debt using its earnings. A rising ratio may indicate increasing Credit Risk.
  $\text{Debt-to-EBITDA} = \frac{\text{Total Debt}}{\text{Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)}}$
• Interest Coverage Ratio: This ratio assesses a company's ability to pay interest on its outstanding debt. A declining ratio suggests difficulty in meeting interest payments.
  $\text{Interest Coverage Ratio} = \frac{\text{Earnings Before Interest and Taxes (EBIT)}}{\text{Interest Expense}}$
  These ratios are key indicators of financial health and potential for a downgrade to High Yield Bond status.

Interpreting the Fallen Angel

Interpreting a fallen angel involves understanding the circumstances of its downgrade and its implications for future performance. When a bond is downgraded to fallen angel status, it typically experiences a significant price decline, and its Yield increases to compensate investors for the higher Credit Risk. This initial negative reaction is often exacerbated by forced selling from institutional investors, such as pension funds and certain Exchange-Traded Funds (ETFs), whose mandates restrict them to holding only Investment Grade securities.¹²,

However, the interpretation does not end there. Some investors view fallen angels as potential value opportunities. These companies, having once been investment grade, are often larger, more established firms with better access to capital markets and a stronger incentive to regain their investment-grade rating.¹¹,¹⁰ Therefore, a fallen angel can be interpreted as an undervalued asset if the underlying issuer is expected to recover from its Financial Distress and eventually be upgraded back to investment grade, a phenomenon sometimes referred to as becoming a "rising star."

Hypothetical Example

Imagine "Global Innovations Inc." has outstanding Corporate Bonds with an S&P credit rating of BBB. Due to a sudden downturn in its primary market, coupled with aggressive expansion funded by debt, Global Innovations Inc. reports significant losses for two consecutive quarters. Its debt-to-EBITDA ratio rises sharply, and its Liquidity position weakens.

In response to these deteriorating financials, Standard & Poor's announces a downgrade of Global Innovations Inc.'s bonds from BBB to BB+. This action immediately reclassifies these bonds as fallen angels. Upon the announcement, the market reacts, and the bond's price falls from 98 cents on the dollar to 85 cents, and its Yield consequently rises. Investment funds that are mandated to hold only Investment Grade debt are forced to sell their holdings, adding to the selling pressure. However, some high-yield bond investors, after assessing the company's long-term prospects and recovery plan, might see this as an opportunity to acquire the bonds at a discounted price, betting on Global Innovations Inc.'s eventual return to financial health.

Practical Applications

Fallen angels have several practical applications and implications in the financial world:

• Investment Opportunities: Many investors, particularly those specializing in the High Yield Bond market, actively seek out fallen angels. They aim to capitalize on the price dislocation that often occurs immediately after a downgrade, which is driven by forced selling rather than solely fundamental deterioration. Research suggests that fallen angels may experience a price rebound after the initial sell-off.⁹ These bonds tend to offer attractive Yield and potential for capital appreciation if the issuer recovers.
• Portfolio Management Strategy: For Portfolio Management, understanding fallen angels is crucial for both investment-grade and high-yield managers. Investment-grade managers must manage the risk of their holdings becoming fallen angels, which can lead to forced sales and portfolio losses. High-yield managers, conversely, may view them as a source of higher-quality additions to their portfolios.
• Market Indicators: A significant increase in fallen angels can serve as an indicator of broader economic stress or a weakening Credit Rating cycle. For example, the year 2020 saw a record number of fallen angels due to the economic impact of the COVID-19 pandemic.⁸,⁷ Such trends can signal an impending Economic Recession or a widespread deterioration in corporate balance sheets.
• Bond Index Rebalancing: Fallen angels impact bond indexes, particularly those that track investment-grade or high-yield segments. When a bond becomes a fallen angel, it is typically removed from investment-grade indexes and added to high-yield indexes, necessitating rebalancing by passive funds and Exchange-Traded Funds (ETFs).⁶

Limitations and Criticisms

While fallen angels can present investment opportunities, they also come with significant limitations and criticisms:

• Elevated Credit Risk: Despite potentially offering value, fallen angels are inherently riskier than their former Investment Grade counterparts. The downgrade indicates a genuine deterioration in the issuer's financial health, and there is no guarantee that the company will recover. Some fallen angels never regain investment-grade status and may eventually default.
• [Market Volatility]: The prices of fallen angel bonds can be highly volatile, particularly around the time of the downgrade and during periods of market stress. This Market Volatility can lead to substantial losses for investors who misjudge the issuer's recovery prospects.
• [Liquidity] Concerns: In periods of widespread downgrades, the sheer volume of fallen angels can strain market Liquidity, making it more challenging to buy or sell these bonds without impacting prices. This can be exacerbated by reduced dealer inventory in the Bond Market.⁵
• Over-reliance on Ratings: Focusing solely on a bond's fallen angel status without conducting thorough fundamental analysis of the underlying issuer can be a pitfall. While credit ratings are important, they are not infallible and may sometimes lag behind market realities. As S&P Global Ratings noted in 2024, the cost of falling to speculative grade remains high for corporates despite some tightening of Spreads.⁴
• Selection Bias: Successfully investing in fallen angels requires careful selection, as not all downgraded bonds will recover. Distinguishing between a temporary setback and a long-term decline in an issuer's viability is critical. Moody's research indicates that recently downgraded firms are more vulnerable to default than other firms with the same speculative grade rating for the first two years after the downgrade.³

Fallen Angel vs. Rising Star

The terms "fallen angel" and "rising star" represent opposite movements within the Credit Rating spectrum, particularly concerning the boundary between Investment Grade and High Yield Bond status.

While a fallen angel has "fallen" from a higher status, a Rising Star has "risen" to a more desirable one. Investors often scrutinize fallen angels for their potential to become rising stars, representing a full circle in their credit journey.

FAQs

What is the primary reason a bond becomes a fallen angel?

A bond primarily becomes a fallen angel due to a deterioration in the issuer's financial condition, such as declining revenues, increasing debt levels, or weakened Liquidity. This leads major Credit Rating agencies to downgrade the bond from Investment Grade to speculative status.²

Are fallen angels considered risky investments?

Yes, fallen angels are considered higher-risk investments than investment-grade bonds because their downgrade signals increased Credit Risk and a higher probability of Default Rate. However, some investors see potential for higher returns if the issuer successfully recovers.

How do fallen angels impact the broader bond market?

Fallen angels can increase the supply of High Yield Bond debt in the Bond Market, potentially influencing Spreads and overall market dynamics. Large waves of fallen angels, such as those seen during economic crises, can signal widespread financial stress and prompt institutional investors to re-evaluate their Portfolio Management strategies.¹