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by JT

Market Vectors thinks that the best way to get ahead in the bond market is with the "Falling Angels," bonds that have fallen from investment grade to below investment grade. Over time, companies that have moved from investment grade to junk have given their debt investors higher returns.

Market Vectors has a new fund for the asset class, the Market Vectors Fallen Angel High Yield Bond ETF (NYSEARCA:ANGL).

Here's what makes this strategy different:

  1. It only buys bonds from companies that were once investment-grade. Debt issued below investment grade never makes the cut.
  2. It usually favors BB-rated debt compared to junk bond funds, which overweight B and CCC-rated securities.
  3. Companies in the index usually have brand value given that they're established players in their respective industries.

Go Long on Falling Angels?

A nice name for a strategy doesn't make it a good investment. There's more to the strategy than simply buying falling angels. Market Vectors finds substantial differences between the companies that fall from investment grade and companies that issue debt at a junk rating: capital structure.

What Van Eck discovered is that companies that fit the falling angel mold usually have qualities that make them preferable to junk issuers. Most importantly, falling angels are more likely to have much longer-dated debt that insulates the company from risk at reissue. Falling angels are also more asset-heavy, having the option to borrow against assets to raise funding.

These qualities make falling angels less risky than other junk debt investments.

This strategy also exploits some rigidity and market inefficiency. Bonds that are downgraded have to be sold by managers who run investment-grade funds, are usually dumped by pensions and institutional investors, and receive less indexing investment interest once a bond is moved to junk status. By selecting fallen angels, investors in this fund start buying when everyone else is selling.

Previously we noted how some bond funds could use scale to exploit inefficiency. There are a tremendous number of junk bond ETFs, many of them based on market indexes which do not include all junk debt. Investment interest in the market is concentrated by these funds, which leads to outperformance for the few investors who actively select junk bonds.

If the company recovers to investment-grade status from junk, investors stand to enjoy lofty capital gains on top of a series of high-interest coupon payments.

The Long Bond in Junk

Falling Angels are a great way to play longer-dated junk securities. The Market Vectors Fallen Angel High-Yield ETF has an average duration of 5.5 years with 5.5% yield-to-maturity. The fund holds securities with an average maturity date of more than ten years.

This Market Vectors fund will naturally do best in periods where interest rates are falling and the business cycle is improving, given its exposure to longer-dated bonds. Those who want a long-term play on improving credit-quality in the United States should consider this fund's 5.4% yield to be highly attractive. Alternatively, there are various other high yield alternatives yielding 5% or higher.

Disclosure: No position in any tickers reviewed in this article.

Source: Buy Falling Angels For Higher Yields