ANGL: Better Than JNK But Watch Credit Spreads

Summary

• ANGL tracks an index of fallen angel bonds: bonds that were investment grade at issuance but have been downgraded to junk status.
• Fallen angels tend to outperform both investment grade and junk bonds overall due to forced selling as they are downgraded.
• However, they are still corporate bonds and follow the credit cycle.

SvetlanaSF

The VanEck Fallen Angel High Yield Bond ETF (NASDAQ:ANGL) provides exposure to 'fallen angel' corporate bonds, which are bonds that were rated investment grade at time of issuance but have been downgraded to junk status. Historically, fallen angels have outperformed both investment grade and junk bonds. They could be a viable alternative for investors seeking junk bond exposure.

Fund Overview

The ANGL fund tracks the ICE US Fallen Angel High Yield 10% Constrained Index ("Index"). The index is comprised of non-investment grade corporate bonds denominated in U.S. dollars that were rated investment grade at the time of issuance. The index contains domestic U.S. issuers as well as non-U.S. issuers, although qualifying securities must be issued in the U.S. market. Non-U.S. issuers may be from the E.U., Australia, Canada, Japan, New Zealand, Norway, Sweden, Switzerland, and the United Kingdom. Single issuer weight is capped at 10% of the index. The index constituents are capitalization weighted, subject to issuer cap, based on their current amount outstanding.

The ANGL ETF has $2.8 billion in assets and charges a 0.35% net expense ratio.

Strategy

A 'fallen angel', as the name suggests, is a bond that was rated investment grade at issuance, but has since been downgraded to junk status by one or more of the rating agencies (S&P, Moody's and Fitch). Bond downgrades typically occur when an issuer experiences financial difficulties such as declining revenues or industry disruptions.

Although some investors view the credit downgrade as a negative, contrarians may find fallen angels attractive, as there is the possibility of the issuer recovering its investment grade status. They are considered higher-quality bonds than the average junk bond.

According to some studies, fallen angels tend to have better credit characteristics than original-issue high yield bonds. The Corporate Finance Institute quote average 12-month default rates of fallen angels of 3.51% vs. 4.51% for original-issue junk bonds, and 4.22% for high yield bonds overall, although the data is unverified.

An article from the Chartered Alternative Investment Analyst Association ("CAIA") claims 'fallen angels are the last free lunch'. The fundamental reason fallen angels tend to outperform is because when a bond issuer falls on hard times and is downgraded below investment grade, investment grade fund managers are forced to remove the securities from their portfolios. This forced selling causes the affected securities to be massively dislocated relative to their underlying business risks as they enter the fallen angel indices. Over time, the business risk is normalized, allowing the fallen angel to outperform similarly rated junk bonds.

According to VanEck's data, fallen angels have historically outperformed high yield indices, with a 100% batting average on a rolling 7 Yr and 10Yr basis since 2004 (Figure 1).

Figure 1 - Fallen angels tend to outperform (vaneck.com)

Portfolio Holdings

Figure 2 shows the ANGL fund's allocation by issuer geography. 83% of the issuers in the ANGL fund is from the U.S., 5% is from Italy, and 4% is from the U.K.

Figure 2 - ANGL geographical allocation (vaneck.com)

As expected, the fund is mostly invested in non-investment grade bonds (BB or below). BB-rated accounts for 80% of assets, while B-rated accounts for 12% and CCC-rated accounts for 2% (Figure 3).

Figure 3 - ANGL credit quality allocation (vaneck.com)

Figure 4 shows the fund's sector allocation. Energy is the largest sector weight in the ANGL fund at 27%, with Consumer Cyclicals at 19%, Technology at 16% and Industrials at 15%. Utilities round out the top 5 sectors at 6%.

Figure 4 - ANGL sector allocation (vaneck.com)

Returns

Figure 5 shows the historical returns of the ANGL ETF. The fund has generated modest long-term returns, with 3, 5, and 10Yr average annual returns of 2.4%, 3.4%, and 5.9% respectively to January 31, 2023.

Figure 5 - ANGL historical returns (morningstar.com)

While ANGL's' returns have been modest on an absolute basis, when compared to a junk bond fund like the SPDR Bloomberg Barclays High Yield Bond ETF (JNK), we can see ANGL has outperformed on all longer-term time frames (Figure 6).

Figure 6 - JNK historical returns (morningstar.com)

Similarly, ANGL has outperformed an investment grade bond fund like the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) on all longer-term time frames (Figure 7).

Figure 7 - LQD historical returns (morningstar.com)

Distribution & Yield

The ANGL ETF pays a modestly high distribution yield with a trailing 12 month distribution of $1.27, which is currently yielding 4.5%. ANGL's distribution is paid monthly.

Free Lunch? What's The Catch?

The theory and historical returns above show that fallen angel investing has outperformed original-issued junk bonds and investment grade bonds over the long-term. Is this the proverbial 'free lunch' or is there a catch?

There are three potential problems with fallen angel investing that I can see. First, in any given year, the number of bond downgrades into junk territory is typically small, so the investment universe is limited. In fact, during good times like in 2018, the number of bond downgrades can be virtually nil (Figure 8).

Figure 8 - S&P BBB downgrades to HY per year (spglobal.com)

At the other extreme, sometimes there are a lot of bonds downgraded at the same time due to systemic events, like the COVID-19 pandemic, which caused a wave of downgrades. When a whole industry like energy was downgraded during COVID, investors turn from betting on an individual company recovering to betting on macro factors like oil prices. That's a fundamentally different bet.

Finally, sometimes companies are downgraded because their industry is being disrupted and there is no recovery. Think about the DVD player disrupting the VCR or Apple's iPhone disrupting Nokia's handset market. In recent years, many large retailers like Sears and JCPenney were disrupted by online retail and their bonds have never recovered. Unfortunately, a passive index will include all fallen angels; fortunately, a portfolio approach should allow winners to smooth out the losers.

Fallen Angels Still Follows The Credit Cycle

While fallen angel investing may outperform over the long run, at the end of the day, they are still corporate bonds that follow the credit cycle. When interest rates go up like they did in 2022, they will still lose money due to duration. When credit spreads widen, fallen angel bond prices will still fall (Figure 10).

Figure 10 - Fallen angels still follow the credit cycle (Author created with price chart from stockcharts.com and high yield spread from St. Louis Fed)

Conclusion

The ANGL ETF provides exposure to 'fallen angel' corporate bonds, which are bonds that were rated investment grade at issuance but have been downgraded to junk status. Historically, fallen angels have outperformed both investment grade and junk bonds. They could be a viable alternative for investors seeking junk bond exposure. However, investors need to be mindful they still follow the credit cycle.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.