When the downgrade is the entry point not the exit 

When a bond is downgraded below investment grade, its price typically comes under pressure. However, this is often amplified by forced selling from investors whose mandates or guidelines no longer permit them to hold the security. Once the bond exits the benchmark, these investors must sell, regardless of valuation, creating a temporary dislocation between price and underlying value.  

Syed Zamil, senior investment strategist at Insight Investment, argues that this is precisely where the return comes from. 

Fallen angels are corporate bonds that issuers originally sold as investment grade, usually rated BBB, and that rating agencies have since downgraded into high yield, usually to BB, the top rung of the sub-investment grade market. They are not distressed credits and they are not small companies. Paramount, Warner Brothers, Yum Brands and Vodafone have all spent time in the universe. 

“These were high quality bonds that have basically run into a speed bump. Either their leverage has gotten a little bit high, or their earnings have declined a little bit, and the rating agencies have slapped them on the wrist,” Zamil says. 

The category stays mispriced partly because it is not worth most managers’ time. On Zamil’s numbers the US investment grade corporate market is around $11 trillion and US high yield around $2 trillion, while fallen angels amount to roughly $120 billion.

“It is a really small universe, and so for a lot of asset managers it is just not a big enough pool of assets for them to really have a dedicated strategy,” he says. 

The discount 

The entry point is visible in the spread history. Twelve months before a downgrade, a bond on its way out of investment grade still trades around 100 basis points tighter than its high yield peers.

Debt levels rise, earnings fall, the market prices it well ahead of the agencies, and by the time the downgrade formally lands the bond enters the fallen angel universe 75 to 100 basis points wider than a comparable high yield credit. 

That shows up in price too. Zamil puts the average price of a fallen angel bond at 91 cents in the dollar at 30 June, and says the figure has hovered near $90 for two decades, where broad high yield oscillates between $90 and $100. 

“The other value proposition is that you are buying them on a fire sale,” Syed Zamil 

The return arithmetic 

On Zamil’s 20-year numbers, global investment grade averaged a starting yield of 3.7 per cent and delivered 3.5 per cent, the small drag coming from downgraded bonds falling out of the benchmark. High yield averaged a starting yield of 7.6 per cent against annual defaults of 2.3 per cent and delivered roughly 90 basis points below its starting yield. 

“I think a lot of investors are so deathly afraid of defaults that they avoid the asset class altogether,” Zamil says. 

Fallen angels, on the same numbers, started at a slightly lower 7.4 per cent and returned more than that, which is the only one of the three cohorts to have done so. The extra came from price recovery rather than from carry, as the forced selling unwound and the companies repaired their balance sheets. 

Sands China, a gaming operator, had bonds that had already underperformed BB peers by close to 20 per cent in the year before its downgrade in June 2022.

However, this rating recovered through the following 12 months as margins improved and returned to investment grade in July 2023. An investor who bought at the downgrade avoided the entire fall and participated in the recovery. 

The cycle 

The pattern is sharpest when downgrades cluster. Zamil says the fallen angel index fell about 25 per cent in 2008 and rose 73 per cent in 2009, and that the 2015 energy shock produced a modest decline followed by a 30 per cent year in 2016. 

Zamil is watching Sekisui House, the Japanese homebuilder that has taken on debt to expand into a weak US housing market and that one agency has already downgraded, alongside Oracle and Ford Motor Company.

“These bonds do not default. They, in fact, more often than not, become rising stars again,” Zamil says. 

The next downgrade wave will settle how well that record holds. The investors who benefit will be the ones who buy before the ratings move, rather than after.