What Is Fallen Angels?
A "fallen angel" is a bond that was initially issued with an investment-grade credit rating but has since been downgraded to non-investment grade, commonly known as junk bond status. This classification falls under the broader category of fixed income securities. The downgrade typically occurs due to a deterioration in the issuer's financial health, leading to an increased credit risk. Fallen angels offer higher yields compared to investment-grade bonds, compensating investors for the elevated risk. The term can also occasionally refer to stocks that have experienced a significant price decline from their peak.
History and Origin
The concept of fallen angels emerged alongside the rise of formal credit rating agencies in the early 20th century, which standardized the assessment of bond creditworthiness. As companies' financial fortunes changed, so too did their bond ratings. A significant aspect of fallen angels' market behavior gained prominence with the growth of institutional investment, particularly after 1975, when the Securities and Exchange Commission (SEC) began to rely on credit ratings from "nationally recognized statistical rating organizations" (NRSROs) for regulatory purposes17,16. This regulatory framework meant that many investment funds and institutional investors were mandated to hold only investment-grade debt. When a bond was downgraded to non-investment grade, these investors were often forced to sell their holdings, creating a period of concentrated selling pressure and often leading to oversold prices for fallen angels. This market dynamic has been observed to create a structural opportunity for outperformance for fallen angels over time15.
Key Takeaways
- Fallen angels are bonds downgraded from investment-grade to non-investment grade status.
- The downgrade typically results from a decline in the issuer's financial condition.
- These bonds generally offer higher yields due to their increased default rate.
- Forced selling by institutional investors can lead to temporary undervaluation of fallen angels.
- Historically, fallen angels have shown a tendency to outperform the broader high yield bonds market.
Formula and Calculation
Fallen angels do not have a specific mathematical formula for their definition or classification, as their status is determined by external credit rating agencies. However, the valuation of a fallen angel bond, like any bond, involves calculating its present value based on its future cash flows (coupon payments and face value) and the prevailing market interest rates. The yield-to-maturity (YTM) is a key metric often calculated for these bonds, reflecting the total return an investor can expect if they hold the bond until maturity.
Where:
- ( P ) = Current market price of the bond
- ( C ) = Coupon payment per period
- ( r ) = Yield to maturity (discount rate)
- ( N ) = Number of periods until maturity
- ( F ) = Face value (par value) of the bond
Interpreting the Fallen Angels
Interpreting fallen angels requires an understanding of both credit analysis and market dynamics. A bond becoming a fallen angel signifies a deterioration in the issuer's creditworthiness, increasing the likelihood of default compared to its previous investment-grade status. However, the market's reaction to such a downgrade, particularly forced selling by investment-grade only funds, can often push the bond's price below its intrinsic value, creating a potential buying opportunity for investors willing to take on higher risk premium.
Hypothetical Example
Imagine "TechCorp," a once-stable technology company, issues bonds with an 'A' rating, indicating investment grade. Due to a sudden downturn in its core business and increasing debt levels, the major credit rating agency downgrades TechCorp's bonds from 'A' to 'BB+', which is now speculative or "junk" status. At this point, TechCorp's bonds become fallen angels. Many large institutional investors, such as pension funds, might be restricted by their investment mandates from holding bonds below investment grade. Consequently, they are forced to sell their TechCorp bonds, even if they believe the company might eventually recover. This influx of selling pressure drives down the bond's market price significantly, increasing its yield. A specialized bond market participant or an investor seeking higher yields and believing in TechCorp's long-term recovery might then purchase these now oversold fallen angel bonds.
Practical Applications
Fallen angels represent a distinct segment within the bond market that can be targeted by specific investment strategies. Fund managers and individual investors may seek to capitalize on the potential mispricing that occurs when a bond transitions from investment grade to high yield. This "fallen angel premium" is partly driven by the technical selling pressure from passive management funds and other investment-grade mandates that are forced to divest14,13. Exchange-Traded Funds (ETFs) and mutual funds specifically focused on fallen angels allow investors to gain diversified exposure to this asset class12. These funds often aim to capture the potential price appreciation as the market re-evaluates the bond's true value after the initial forced selling subsides11. Despite higher overall credit risk, fallen angels have historically exhibited a lower average default rate and higher credit quality compared to the broader high-yield universe, with a significant portion being BB-rated10,9. As of early 2025, while the number of corporate defaults remains elevated, the downgrade rate has fallen, and the upgrade rate has increased, suggesting improved credit quality broadly across the market8.
Limitations and Criticisms
Investing in fallen angels carries inherent risks and limitations. While the potential for outperformance exists due to the overselling phenomenon, there is no guarantee that every fallen angel will recover or that its price will rebound. Some companies whose bonds become fallen angels may continue to deteriorate financially, potentially leading to default. For instance, a company failing to innovate or facing intense competition may not recover.
Furthermore, the very nature of credit ratings, which define fallen angels, has faced scrutiny. Credit rating agencies, such as Moody's, Standard & Poor's, and Fitch, play a crucial role in the securities markets by assessing creditworthiness7,6. However, their business model, where issuers pay for ratings, has historically raised concerns about potential conflicts of interest and the accuracy of ratings, particularly leading up to financial crises5. Although the SEC has implemented regulations aimed at enhancing oversight and transparency of NRSROs, criticisms persist regarding their effectiveness in preventing rating inflation or ensuring accountability4,3. Investors should not solely rely on a credit rating but conduct their own comprehensive due diligence and research2. Additionally, the relatively narrow universe of fallen angels, coupled with higher trading costs and lower liquidity in this segment, can present implementation challenges for investors1.
Fallen Angels vs. Rising Stars
Fallen angels are distinct from "rising stars." While fallen angels begin as investment-grade bonds that are subsequently downgraded to speculative (junk) status, rising stars are bonds that initially had a speculative-grade rating but have since been upgraded to investment grade. Rising stars typically achieve this status due to improving financial performance, reduced debt, or stronger market conditions for their issuer. The confusion between the two terms often arises because both describe a change in a bond's credit rating, but in opposite directions of quality. Fallen angels move from higher quality to lower quality, while rising stars move from lower quality to higher quality.
FAQs
Why are fallen angels often considered attractive to investors?
Fallen angels can be attractive because the forced selling by investment-grade-only funds after a downgrade can push their prices below fair value, creating a potential opportunity for price appreciation if the issuer's financial health stabilizes or improves. This allows investors to potentially acquire higher-yielding bonds at a discount.
How do credit rating agencies influence fallen angels?
Credit rating agencies, such as Moody's, S&P, and Fitch, are responsible for assigning and monitoring the creditworthiness of bonds. When an agency downgrades a bond from investment grade to speculative grade, it officially designates it as a fallen angel, triggering investment mandates for many institutional investors to sell.
What are the main risks associated with investing in fallen angels?
The primary risk with fallen angels is that the issuing entity's financial condition may continue to deteriorate, potentially leading to a bond default or further price declines. While some fallen angels recover, others do not, and investors face the uncertainty of the issuer's long-term viability.
Can fallen angels be part of a diversified portfolio?
Yes, fallen angels can be included in a diversified portfolio, often through specialized funds or ETFs, to potentially enhance returns. While they carry higher risk than traditional investment-grade bonds, their historically distinct performance drivers can offer diversification benefits when balanced with other asset classes and investment strategies within a broader asset allocation framework.