Fallenangel

What is a Fallen Angel? Bond Downgrades and Investment Insights

Key Takeaways

A fallen angel is a bond downgraded from investment-grade to junk status due to the issuer's financial struggles.
Fallen angels can offer higher yields but carry increased risk compared to investment-grade bonds.
Some investors find value in fallen angel bonds, expecting the issuer to recover from financial issues.
Funds like VanEck Vectors Fallen Angel ETF invest in these bonds, providing diversified exposure.
Contrarian investors may see opportunities in fallen angels if recovery prospects are favorable.
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What Is a Fallen Angel?

A fallen angel is a term used in finance to describe a bond that initially had an investment-grade rating but has been downgraded to junk status because of the issuer's declining financial health. These bonds typically offer higher yields because they are considered riskier due to the issuer's financial troubles.

Find out what factors lead to a bond becoming a fallen angel, and how ratings agencies like Standard & Poor's and Moody's determine these downgrades. We'll explain the potential risks and rewards of investing in them and give you examples of investment strategies that focus on these securities.

Understanding Fallen Angel Bonds

Fallen angel bonds have been downgraded by one of the major rating services, which include Standard & Poor’s, Fitch, and Moody’s Investors Service. They may be corporate, municipal, or sovereign debt.

The primary reason for a downgrade is a decline in revenues, which jeopardizes the ability of the issuers to pay the interest due on their bonds. If the declining revenues are combined with increasing levels of debt, the potential for a downgrade increases dramatically.

Fallen angel securities are often attractive to contrarian investors seeking to capitalize on the potential for a company to recover from a temporary setback. Under these circumstances, the downgrade process usually starts with the company's debt being placed on a negative credit watch. That alone forces many portfolio managers to sell their positions, as their governing rules may forbid holding them.

Impact of Junk Status on Bond Selling

The actual downgrade to junk status drives more selling pressure, particularly from funds that are restricted to holding investment-grade debt exclusively. As a result, fallen angel bonds can present value within the high-yield category but only if the issuer appears to have a reasonable chance of recovering from the conditions that caused the downgrade.

Investing in Fallen Angel Bond Funds

There are even fallen angel bond funds for investors who spot opportunity at a fire sale. The VanEck Vectors Fallen Angel High-Yield Bond ETF invests only in bonds that have been downgraded. As of September 2021, its holdings included bonds from Sprint Capital Corp., Vodafone Group PLC, and Freeport McMoran, among others.1 There also is the iShares Fallen Angels USD Bond ETF which, as its name suggests, invests only in dollar-denominated fallen angels.2

The Risks of Investing in Fallen Angels

An oil company that has reported sustained losses over several quarters due to falling oil prices may see its investment-grade bonds downgraded to junk status due to the company's increased risk of default. As a result of the downgrade, the prices of the company’s bonds will decline and its yields will increase. That makes them attractive to contrarian investors who see low oil prices as a temporary condition.

Important

Municipal bonds from troubled cities with declining tax revenues are in danger of being downgraded.

Some fallen angels don't come back. For example, a company will experience declining revenues if a better product than theirs appears on the market. If the company fails to innovate, it won't come back. The progression from VCR tapes to DVDs to streaming video is an example.

Municipal and sovereign debt issuers may also see their investment-grade bonds downgraded to junk status due to a combination of stagnant or declining tax revenues and increasing levels of debt. These conditions can create a downward spiral toward default as debt repayments eat into declining revenues and yet more bonds are issued to cover the shortfall.

Sooner or later, that municipal or national government is going to miss a payment.

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VanEck. "VanEck Fallen Angel High Yield Bond ETF." Accessed Sept. 13, 2021.

iShares. "iShares Fallen Angels USD Bond ETF." Accessed Sept. 13, 2021.

Investing

Bonds