Here’s what a ‘fallen angel’ is and why you might want to catch one in 2023
Bonds and fixed income have been much out favour for several years. Low interest rates made it difficult for the sector to compete against dividend yields combined with growth of equities.
But Insight Investment Director Australia and New Zealand Bruce Murphy told Stockhead fixed income is looking much more attractive to investors with the accelerated tightening regime.
“What we’ve seen now with consecutive rounds of rate rises is that the relative attractiveness of bonds has improved,” he said.
“Now bonds can take a role which is more akin to what it was in the past which is balancing the portfolio but also providing yield.”
And one sector of the fixed income market providing opportunities is fallen angels. For the uninitiated, fallen angels are bonds which are rated BB having been downgraded from investment grade or BBB rating and now sit at the top of the high yield market.
While they’ve been downgraded, some are poised to return to investment grade status. They’re known as rising stars.
Murphy takes a particular interest in income solutions for investors and has developed a range of products covering annuities, allocated pensions and bond strategies in his career spanning more than 30 years.
His latest product is the Insight Investment High Income Fund, which focuses on the US Fallen Angels bond index, hedged to remove USD currency risk for Australian dollar investors.
He said the strategy does not invest in Australian fallen angels per se as the market is too narrow.
“The attractiveness comes from a lot of institutional holders who, when the downgrade occurs, can’t hold a fallen angel due to their investment guidelines,” he said.
“So, there are a lot of forced sellers when a company gets downgraded, which means you can pick them up at a really good price at that point of entry.”
Murphy said typically the market realises the balance sheet and business of fallen angel is sound.
“The discount from the forced selling dissipates and you can make some nice returns typically in the first months while it’s in the index,” he said.
Murphy said corporates strive to be re-rated back to rising star because when they move into double B, the cost of funding rises so investors stand to make another profit if the corporate is successful in eventually being re-rated back up to investment grade.
“That’s the opportunity picking up on the forced sellers discount and watching them come back,” he said.
Murphy said with current cash rate in Australia at 3.1% on an investment grade bond in the public bond market, you can get a credit spread or reward for the risk you’re taking of about 125 basis points or 1.25%.
But Murphy said if you go one notch further to double B at the top end of the high yield market you can get a credit spread of 350 basis points.
“So suddenly you add that to a cash rate of 3.1% and you contrast it to term deposits which are sitting around 3.75% for six months and you have a really viable position,” he said.
Murphy said high yield markets can be illiquid so to get a portfolio you need to be very innovative in trading techniques.
“For example, rather than single high yield bonds with transaction costs in the order of 80 to 120 basis points you have to innovate and trade in baskets of bonds,” he says.
“When we set the portfolio for our high-income strategy, we managed to get 232 bonds in eight trades.
“So, we trade baskets and operate in the ETF ecosystem where they have index-like exposures in broadly diversified portfolios.
“Our view is that if we can basket and portfolio trade like that, we can create liquidity because that ETF market is highly liquid, and we can do it at much lower cost which is key to us.”
Murphy said the other key to the implementation of their high-income fund strategy is not necessarily thinking you can win by having a concentrated portfolio of fallen angels.
“The sector’s beauty is the index itself and the structural alpha opportunity at the downgrade point following on from that typically is very strong,” he said.
“We do a credit overlay to make sure we don’t pick up any very, very poor credits, but the game is to try to implement something reasonably close to the index.”
Murphy said bonds haven’t been as popular in Australia as other countries like the UK where they may comprise up to 50% of a portfolio and there is a higher level of familiarity.
He said this is in part because Australia has a defined contribution superannuation market.
“There’s an argument that if you are 20, 30 or 40 you should go 100% growth assets and the average allocation in Australia at the aggregate level to global bonds is around 7%, so always very low,” he said.
“The world has changed, and relative attractiveness of bonds has changed but we still need to break down some myths.”
Murphy said while there’s been a stronger funds flow into private debt which is starting to form a bigger part of portfolios, there are still good opportunities in public debt.
“You can have liquidity – one because it’s public and two because of trading innovation – and still have consistent income,” he said.
He said bonds are very good at providing a more certain outcome for investors, which drives their attractiveness in other markets.
“With a bond you’re more likely to be paid a contractual coupon than a dividend on a share that hasn’t been declared,” he said.
Murphy said when investing in credit, such as fallen angels, you are taking market risk so it’s not the same as a term deposit.
“Our portfolio tracks closely to the index and historically we can see there have been periods of drawdowns,” he said.
“But the big difference is relative to equities they bounce back much quicker.
“Whenever there’s been market dislocation and problems where it can take 24 months or more for equities to return to previous levels, it typically takes six to 12 months for high yield and sometimes is much quicker.”
The views, information, or opinions expressed in the interviews in this article are solely those of the interviewees and do not represent the views of Stockhead. Stockhead does not provide, endorse or otherwise assume responsibility for any financial product advice contained in this article.