What Is a Fallen Angel?
A fallen angel is a bond that was initially issued with an investment grade credit rating but has since been downgraded to "junk" status, also known as a high yield bond. This transition typically occurs when the financial health of the issuing company deteriorates, leading credit rating agencies to lower their assessment of the company's ability to meet its debt obligations. The phenomenon of a fallen angel is a significant event in the fixed income market, impacting both the issuer's borrowing costs and investors' portfolio valuations.
History and Origin
While the concept of a company's financial standing deteriorating and impacting its debt has always existed, the term "fallen angel" gained prominence in the financial lexicon, particularly as the corporate bonds market expanded significantly. A notable period for the creation of fallen angels was following the 2008 Global Financial Crisis. Research from the Federal Reserve Bank of San Francisco indicates that since 2009, the BBB segment of the corporate bond market, which is just above the investment-grade threshold, has tripled in size. This growth, coupled with factors like quantitative easing (QE) and the sluggish adjustment of credit ratings for risky BBB issuers, contributed to a wave of downgrades, especially at the onset of the COVID-19 pandemic, creating an "unprecedented wave" of fallen angels.6
Key Takeaways
- A fallen angel is an investment-grade bond that has been downgraded to non-investment-grade, or junk, status.
- This downgrade typically occurs due to a deterioration in the issuer's financial health, increasing their default risk.
- The reclassification can trigger forced selling by institutional investors with mandates to hold only investment-grade securities.
- Fallen angels often experience an initial price drop, followed by potential recovery if the market reassesses their long-term prospects.
- They can offer higher yield opportunities for investors willing to take on increased risk.
Interpreting the Fallen Angel
When a bond becomes a fallen angel, it signifies a reassessment of the issuer's creditworthiness. Investors interpret this as an increased likelihood that the company may struggle to make its interest payments or repay the principal. The immediate consequence is usually a decline in the bond's price and an increase in its yield to compensate for the higher perceived risk. The extent of this price adjustment depends on market sentiment, the severity of the downgrade, and the overall health of the bond market. For some investors, a fallen angel can represent a potential opportunity if they believe the market has overreacted to the downgrade and the company's fundamentals will improve.
Hypothetical Example
Consider "Tech Innovations Inc." which has $500 million in corporate bonds outstanding, rated BBB- by a major credit rating agency. This rating places them at the lowest rung of investment grade. Due to a sudden downturn in their primary market and a significant loss of a key contract, Tech Innovations Inc. reports a substantial drop in revenue and a widened net loss for two consecutive quarters.
As a result, the credit rating agency reviews Tech Innovations Inc.'s financials and decides to downgrade their bonds to BB+, moving them from investment grade to junk bond status. Tech Innovations Inc.'s bonds are now considered a fallen angel. This event would typically lead to a sharp decline in the bond's market price as investors, particularly those with mandates to hold only investment-grade assets, are forced to sell. The bond's yield would increase to attract new buyers willing to assume the elevated default risk.
Practical Applications
Fallen angels are a direct result of changes in a company's financial strength and show up primarily in the bond market. They are closely watched by various participants:
- Fixed Income Investors: Investors who specialize in high yield bond strategies often seek out fallen angels, as these bonds can be undervalued immediately after a downgrade due to forced selling by investment-grade holders.
- Credit Analysts: Analysts monitor companies on the cusp of a downgrade to identify potential fallen angels, assessing their financial metrics and industry outlook to predict credit rating actions.
- Risk Management: Financial institutions must manage the exposure of their portfolio to fallen angels, as these bonds carry higher default risk and can impact overall portfolio performance.
- Economic Indicators: A surge in fallen angels across various sectors can signal broader economic distress or a tightening of credit rating standards. For instance, the COVID-19 pandemic led to a significant increase in fallen angels, with S&P's count hitting 34 issuers with over $320 billion in rated debt during 2020, including major corporations like Ford and Delta Air Lines.5,4 VanEck, an investment management firm, also highlighted that 2020 was expected to be a record year for fallen angels due to the pandemic's economic shock.3
Limitations and Criticisms
While fallen angels can present opportunities, they come with significant limitations and criticisms. The primary concern is the increased default risk associated with their lower credit rating. Investors buying fallen angels are taking on more risk in exchange for a potentially higher yield.
One criticism revolves around the market's reaction to downgrades. Research indicates that bond prices of issuers downgraded from investment grade to high yield bond status often fall before the official downgrade and continue to fall for a period afterward. However, average prices may then rise, suggesting a potential for recovery.2 This implies that the initial market overreaction, particularly due to forced selling by institutions whose mandates prohibit holding non-investment-grade securities, can create temporary dislocations. This forced selling, while a limitation for some investors, can create opportunities for others who are unconstrained by investment-grade mandates. Another limitation is that the market for fallen angels can be less liquid than the investment grade market, making it harder to buy or sell these bonds quickly without significantly impacting their price. The overall economic environment, particularly periods of high interest rates or quantitative easing, can also influence the volume and performance of fallen angels.1
Fallen Angel vs. Rising Star
The terms "fallen angel" and "rising star" represent opposite trajectories in the bond market. A fallen angel, as discussed, begins as an investment grade bond but is subsequently downgraded to junk bond status due to a worsening financial outlook. This transition signifies a decline in credit quality and an increase in default risk.
Conversely, a rising star is a bond that was initially issued with a non-investment-grade (junk) credit rating but has since been upgraded to investment grade. This occurs when the issuing company's financial health significantly improves, leading credit rating agencies to view its debt as less risky. While a fallen angel implies a negative shift in perception and often a sharp price drop, a rising star implies a positive shift, usually resulting in an increase in the bond's price and a decrease in its yield as it becomes more attractive to a wider range of investors, including those with investment-grade mandates.
FAQs
What causes a bond to become a fallen angel?
A bond becomes a fallen angel primarily due to a deterioration in the issuer's financial condition. This could be triggered by factors such as declining revenues, increasing debt, poor management decisions, economic downturns, or significant negative industry shifts that lead credit rating agencies to downgrade its bonds from investment grade to junk bond status.
Are fallen angels good investments?
Fallen angels are considered speculative investments due to their increased default risk. However, for investors with a higher risk tolerance and specialized knowledge, they can present opportunities. If the market has overreacted to the downgrade, or if the company's prospects improve, these bonds might offer attractive returns. A robust diversification strategy is crucial when considering such securities for a portfolio.
How do fallen angels impact the broader market?
While fallen angels represent a small segment of the overall bond market, a significant volume of them can signal broader economic weakness. They can also affect market liquidity, as institutional investors may be forced to sell substantial amounts of bonds, increasing supply in the high yield bond market and potentially widening credit spreads. This was notably observed during the COVID-19 pandemic.