Credit downgrades can be an opportunity for high yield investors. Our multi-factor credit strategy is able to distinguish between fallen angels that will subsequently recover and those that will remain weak.
The coronavirus pandemic and subsequent demand crisis has led to an unprecedented surge in the number of bonds downgraded from an investment grade rating to high yield (so-called ‘fallen angels’).
For a corporate bond investor, the implication of such a downgrade depends on the perspective. An investment grade investor would consider fallen angels a threat, while a high yield investor would typically view them as an opportunity. In this article we investigate the performance of fallen angels, and show how we are able to distinguish between fallen angels that will subsequently recover and those that will remain weak.
Rating agencies continually evaluate ratings, potentially leading to an upgrade or downgrade of a company’s rating. The price impact directly after an upgrade or downgrade is usually small, because the change in creditworthiness is priced in beforehand.1 The exception is a rating change that moves a bond from investment grade to high yield, or from high yield to investment grade, because constrained investors are forced to quickly sell their positions. For fallen angels, this mechanism can even lead to serious market inefficiencies, because the supply of fallen angels from the investment grade market is often too large to be efficiently absorbed by the smaller high yield market.
To assess the price pattern of fallen angels, we perform an event study on a 36-month window around the downgrade date, where the window starts 12 months before the downgrade and ends 24 months thereafter. Month 0 marks the point where the bond is downgraded (intra-month) and from month 1 onwards the bond is part of the high yield universe.
Figure 2 shows the results of the event study, averaged over all events in the January 1994 to June 2020 research period. The credit spread of a fallen angel is shown in Panel A and shows a three-phase pattern: widening ahead of the downgrade, inflection around the downgrade date and tightening thereafter. There is not a full recovery, though, owing to the higher risk associated with the acquired high yield rating.
Because it is likely that movements in market spreads influence the credit spread pattern, we next compare the returns of fallen angels to peers in terms of credit rating, sector and maturity.2 The cumulative outperformance of fallen angels around the downgrade is shown in Panel B of Figure 2. It shows the same three-phase pattern as Panel A, but inverted (as returns and spreads move in opposite directions). Fallen angels underperform their peers a few quarters before the event; especially in the last quarter, and most strongly in the month of the downgrade, when the forced selling of constrained investors pushes the price down even further. Thereafter, relative performance turns positive and stays positive for up to 24 months after the downgrade, as high yield investors start buying the fallen angels and the downgraded companies start taking measures to repair their creditworthiness.
This performance pattern indicates that selling a bond directly after the downgrade is likely to be the worst possible moment to do so.
Given the above results, the question arises whether an investor should simply buy all fallen angels, or if there is a way to distinguish between fallen angels that subsequently recover and those that don’t.
This is where our extensive experience with the value factor comes into play, as it is used to identify the attractiveness of corporate bonds given their risk. In other words, it assesses whether a bond is attractively priced (‘cheap’), or not (‘expensive’).3 To test the ability of the value factor to select the ‘right’ fallen angels, we compare the performance of fallen angels with high value scores in the month after the downgrade (top quintile, ‘Q1’) to the performance of fallen angels with low value scores (bottom quintile, ‘Q5’).
Panel A in Figure 3 shows the cumulative outperformance against peers for these cheap and expensive fallen angels, according to our value factor; Panel B shows the performance difference between the two groups. The cheap fallen angels (Value Q1, blue line) underperform more until the downgrade, after which they start to considerably outperform the more expensive fallen angels (Value Q5, orange line). In fact, the cheap fallen angels perform so well after the downgrade that the event window-return turns positive.
The expensive fallen angels, on the other hand, do not experience much of a reversal at all. So instead of buying all fallen angels indiscriminately, by using our value factor, we can discern outperforming from underperforming fallen angels.
Our Multi-Factor Credits and Multi-Factor High Yield strategies invest in fallen angels based on their attractiveness from a factor perspective. This research reinforces our belief that the bottom-up approach to investing in our multi-factor credit strategies is warranted.
1See e.g. Norden, Weber, 2014, “Informational Efficiency of Credit Default Swap and Stock Markets: The Impact of Credit Rating Announcements”, Journal of Banking & Finance
2To construct the peer groups, we use the methodology of Ben Dor and Xu, 2011, “Fallen Angels: Characteristics, Performance, and Implications for Investors”, Journal of Fixed Income; peer groups are defined based on industry (financials, industrials, and utilities) and credit quality (A and higher, BBB, BB, B, and CCC and lower); in addition, with the exception of the lowest credit-quality category, separate buckets are constructed for short/intermediate and long maturity bonds (up to ten years and above ten years, respectively), resulting in a total of 27 peer groups.
3See our 2016 white paper “Smart Credit Investing: The Value Factor”.
The contents of this document have not been reviewed by the Securities and Futures Commission ("SFC") in Hong Kong. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. This document has been distributed by Robeco Hong Kong Limited (‘Robeco’). Robeco is regulated by the SFC in Hong Kong.
This document has been prepared on a confidential basis solely for the recipient and is for information purposes only. Any reproduction or distribution of this documentation, in whole or in part, or the disclosure of its contents, without the prior written consent of Robeco, is prohibited. By accepting this documentation, the recipient agrees to the foregoing
This document is intended to provide the reader with information on Robeco’s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. Investment decisions should only be based on the relevant prospectus and on thorough financial, fiscal and legal advice. Please refer to the relevant offering documents for details including the risk factors before making any investment decisions.
The contents of this document are based upon sources of information believed to be reliable. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.
Investment Involves risks. Historical returns are provided for illustrative purposes only and do not necessarily reflect Robeco’s expectations for the future. The value of your investments may fluctuate. Past performance is no indication of current or future performance.
Please read this information carefully.
This website is prepared and issued by Robeco Hong Kong Limited ("Robeco"), which is a corporation licensed by the Securities and Futures Commission in Hong Kong to engage in Type 1 (dealing in securities); Type 4 (advising in securities) and Type 9 (asset management) regulated activities. The Company does not hold client assets and is subject to the licensing condition that it shall seek the SFC’s prior approval before extending services at retail level. This website has not been reviewed by the Securities and Futures Commission or any regulatory authority in Hong Kong.
2. Important risk disclosures
2. Important risk disclosures Robeco Capital Growth Funds (“the Funds”) are distinguished by their respective specific investment policies or any other specific features. Please read carefully for the risks of the Funds:
3. Local legal and sales restrictions
The information contained in the Website is being provided for information purposes.
Neither information nor any opinion expressed on the Website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. The information contained in the Website does not constitute investment advice or a recommendation and was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. An investment in a Robeco product should only be made after reading the related legal documents such as management regulations, prospectuses, most recent annual and semi-annual reports, which can be all be obtained free of charge at www.robeco.com/hk/en and at the Robeco Hong Kong office.
4. Use of the Website
The information is based on certain assumptions, information and conditions applicable at a certain time and may be subject to change at any time without notice. Robeco aims to provide accurate, complete and up-to-date information, obtained from sources of information believed to be reliable. Persons accessing the Website are responsible for their choice and use of the information.
5. Investment performance
No assurance can be given that the investment objective of any investment products will be achieved. No representation or promise as to the performance of any investment products or the return on an investment is made. The value of your investments may fluctuate. The value of the assets of Robeco investment products may also fluctuate as a result of the investment policy and/or the developments on the financial markets. Results obtained in the past are no guarantee for the future. Past performance, projection, or forecast included in this Website should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. Fund performance figures are based on the month-end trading prices and are calculated on a total return basis with dividends reinvested. Return figures versus the benchmark show the investment management result before management and/or performance fees; the fund returns are with dividends reinvested and based on net asset values with prices and exchange rates of the valuation moment of the benchmark.
Investments involve risks. Past performance is not a guide to future performance. Potential investors should read the terms and conditions contained in the relevant offering documents and in particular the investment policies and the risk factors before any investment decision is made. Investors should ensure they fully understand the risks associated with the fund and should also consider their own investment objective and risk tolerance level. Investors are reminded that the value and income (if any) from shares of the fund may be volatile and could change substantially within a short period of time, and investors may not get back the amount they have invested in the fund. If in doubt, please seek independent financial and professional advice.
6. Third party websites
This website includes material from third parties or links to websites maintained by third parties some of which is supplied by companies that are not affiliated to Robeco. Following links to any other off-site pages or websites of third parties shall be at the own risk of the person following such link. Robeco has not reviewed any of the websites linked to or referred to by the Website and does not endorse or accept any responsibility for their content nor the products, services or other items offered through them. Robeco shall have no liability for any losses or damages arising from the use of or reliance on the information contained on websites of third parties, including, without limitation, any loss of profit or any other direct or indirect damage. Third party off-site pages or websites are provided for informational purposes only.
7. Limitation of liability
Robeco as well as (possible) other suppliers of information to the Website accept no responsibility for the contents of the Website or the information or recommendations contained herein, which moreover may be changed without notice.
Robeco assumes no responsibility for ensuring, and makes no warranty, that the functioning of the Website will be uninterrupted or error-free. Robeco assumes no responsibility for the consequences of e-mail messages regarding a Robeco (transaction) service, which either cannot be received or sent, are damaged, received or sent incorrectly, or not received or sent on time.
Neither will Robeco be liable for any loss or damage that may result from access to and use of the Website.
8. Intellectual property
All copyrights, patents, intellectual and other property, and licenses regarding the information on the Website are held and obtained by Robeco. These rights will not be passed to persons accessing this information.
10. Applicable law
The Website shall be governed by and construed in accordance with the laws of Hong Kong. All disputes arising out of or in connection with the Website shall be submitted to the exclusive jurisdiction of the courts of Hong Kong.