What Is Acquired Fallen Angel?
An acquired fallen angel refers to a bond that was initially issued with an investment-grade bond rating but has since been downgraded to high-yield bonds, also known as junk bonds, and subsequently purchased by an investor or entity. This term is primarily associated with fixed income investing and highlights a specific strategy within the broader market for restructured or undervalued debt. The downgrade typically results from a deterioration in the issuer's credit rating, often due to financial difficulties or increased leverage, which may stem from events like large mergers and acquisitions.
History and Origin
The concept of "fallen angels" in the bond market emerged as the structured finance landscape developed, particularly with the rise of credit rating agencies. These agencies began assigning investment-grade ratings to corporate bonds in the early 20th century. Over time, as economic conditions shifted or individual companies faced financial distress, some of these once-stable investment-grade bonds would lose their coveted status. The volume of debt downgraded from investment-grade to speculative-grade, particularly BBB-rated bonds, increased significantly after the Global Financial Crisis, with an unprecedented surge during the COVID-19 pandemic in March 2020.16 This created opportunities for investors specializing in the higher-risk, higher-reward high-yield market to acquire these newly downgraded securities.15
Key Takeaways
- An acquired fallen angel is an investment-grade bond that has been downgraded to junk status and subsequently purchased by an investor.
- The downgrade typically occurs due to the issuer's deteriorating financial health.
- These bonds often present a unique investment opportunity as forced selling by institutional investors can drive their bond prices down below their fundamental value.
- Investors in acquired fallen angels seek to profit from a potential rebound in the bond's value if the issuer's financial condition improves or if the market reassesses its risk.
- This strategy is a subset of distressed debt investing.
Interpreting the Acquired Fallen Angel
Interpreting an acquired fallen angel involves assessing why the bond was downgraded and the likelihood of the issuer's recovery. When a bond becomes a fallen angel, institutional investors with mandates limiting them to investment-grade securities are often forced to sell, creating selling pressure and potentially pushing prices below fair value.14 For an investor acquiring such a bond, the interpretation hinges on a thorough understanding of the issuer's underlying financial health, its capacity for debt restructuring or operational turnaround, and the broader economic cycle. The goal is to identify situations where the market's reaction to the downgrade has been an overcorrection, presenting a value opportunity.
Hypothetical Example
Consider "Tech Innovations Inc.," a hypothetical company with $500 million in outstanding corporate bonds that were rated A- by a major credit rating agency. Tech Innovations faces unexpected competition and a significant product recall, leading to a sharp decline in revenue and increased debt. The credit rating agency subsequently downgrades Tech Innovations' bonds from A- to BB+, stripping them of their investment-grade status and reclassifying them as high-yield.
Many large institutional funds, restricted to holding only investment-grade debt, are forced to sell their Tech Innovations bonds. This creates a surge in supply and causes the bonds' market price to drop from 98 cents on the dollar to 75 cents on the dollar. A specialized distressed debt fund, identifying that Tech Innovations' core business remains viable and management is enacting a credible turnaround plan, decides to purchase $50 million of these now "fallen angel" bonds at 75 cents on the dollar. The fund's strategy is that if Tech Innovations stabilizes and its creditworthiness improves over the next two years, the bonds could recover closer to their par value, offering a significant capital gain in addition to the higher yield. The fund conducts extensive due diligence on the company's financials and recovery prospects before making the acquisition.
Practical Applications
Acquired fallen angels are a key component of certain investment strategies, particularly within the high-yield bond market and distressed debt funds. These bonds often exhibit unique characteristics that can be appealing to investors seeking higher returns. For instance, studies have shown that bonds downgraded from investment-grade can experience significant price declines before and immediately after the downgrade, followed by a potential rebound.13 This phenomenon is partly driven by forced selling from institutions that must divest non-investment-grade assets due to regulatory or internal mandates.12
A practical application involves dedicated "fallen angel" bond exchange-traded funds (ETFs) and mutual funds that systematically invest in these securities. For example, some funds aim to track indices composed of U.S. high-yield corporate bonds that were previously investment-grade.11,10 This allows investors to gain exposure to a segment of the market that historically may offer higher quality within the high-yield universe, as many fallen angels were once highly rated companies. Such strategies capitalize on the market's initial overreaction to downgrades, aiming to capture the subsequent price recovery.9 Acquisitions of such debt can also be part of broader distressed company acquisition strategies, where the debt acquisition may precede or be part of a larger corporate restructuring or takeover. According to a report from The Harvard Law School Forum on Corporate Governance, trading in distressed debt requires careful consideration of information to avoid issues, especially in light of potential SEC actions related to insider trading.8
Limitations and Criticisms
Investing in acquired fallen angels, while potentially lucrative, carries significant risks and limitations. The primary criticism is the inherent speculative nature of the investment. While the "fallen angel" bond may have been oversold, there is no guarantee that the issuer's financial condition will improve; it could further deteriorate, leading to default. In such cases, investors face the risk of losing a substantial portion or even all of their capital, especially if the debt is unsecured debt rather than secured debt.
Another limitation stems from the very reason for their initial appeal: the downgrade. The underlying issues that led to the company's financial distress, such as declining profitability, heavy debt loads, or structural industry changes, may be persistent. Academic research indicates that while some firms recover, others continue to struggle, and acquisitions of distressed firms, especially those in bankruptcy, do not always yield positive returns for the acquirer over the long term.7,6 The market for distressed assets can also be illiquid, making it challenging to exit positions quickly without impacting price. Furthermore, the act of acquiring these bonds requires extensive due diligence and expertise in assessing companies in crisis.
Acquired Fallen Angel vs. Distressed Company Acquisition
While closely related, an acquired fallen angel and a distressed company acquisition refer to distinct, though sometimes overlapping, investment activities.
An acquired fallen angel specifically pertains to the purchase of debt securities (bonds) that have been downgraded from investment-grade to sub-investment-grade (junk) status. The focus is on the bond itself and the potential for its market price to recover as the issuer stabilizes or the market corrects its initial reaction. Investors typically aim to profit from the price appreciation of the bond or its higher yield. The acquiring party is primarily a debt investor.
Conversely, a distressed company acquisition involves purchasing an entire company or a significant portion of its assets when it is in financial distress, nearing insolvency, or in bankruptcy. This can be a share sale or an asset sale.5 The acquiring entity, often a private equity firm or a strategic buyer, aims to restructure the company, improve its operations, or integrate its assets into an existing business to unlock long-term shareholder value. While the distressed company may have fallen angel bonds outstanding, the acquisition is focused on the equity or operational control of the enterprise, not just the debt instruments. An acquisition of a distressed business can be an out-of-court transaction or occur within the framework of a bankruptcy proceeding, such as a Section 363 sale.4
FAQs
What causes a bond to become a fallen angel?
A bond becomes a fallen angel when its issuer's credit rating is downgraded from investment-grade to sub-investment-grade, or junk status. This typically happens due to a deterioration in the issuer's financial health, such as rising debt, declining revenues, or significant operational challenges.
Why do investors acquire fallen angels?
Investors acquire fallen angels because the forced selling by institutional investors, whose mandates often prohibit holding junk bonds, can push the bond's price below its intrinsic value. This creates a potential opportunity for capital appreciation if the issuer recovers or the market re-evaluates the bond's risk.3
Is investing in acquired fallen angels risky?
Yes, investing in acquired fallen angels carries significant risk. While there's potential for high returns, the issuer is by definition in financial distress, and there's a risk of further deterioration or even default, which could lead to substantial losses.
How does an acquired fallen angel differ from a general high-yield bond?
A general high-yield bond is issued with a speculative-grade rating from the outset. An acquired fallen angel, however, began as an investment-grade bond and was subsequently downgraded. This distinction often means fallen angels come from larger, more established companies and may have historically exhibited different credit quality and performance characteristics within the broader high-yield market.2
What is the role of liquidity in the fallen angel market?
Liquidity can be a significant factor in the fallen angel market. When a bond is downgraded, the sudden surge of forced selling can temporarily depress its bond prices. While this creates opportunities for buyers, it also means that the market for these bonds can become less liquid during periods of distress, making it harder for investors to buy or sell large positions without impacting the price.1