Fallen Angel ETFs Have Outperformed With Yields Around 7% - but Are Risky

There's a segment of the bond market, often overlooked by investors, that is currently outperforming: "fallen angels." These bonds have recently been downgraded from investment grade to high yield. Two exchange-traded funds (ETFs) specialize in this niche: iShares Fallen Angels USD Bond ETF (FALN) and VanEck Fallen Angel High Yield Bond ETF (ANGL). FALN boasts a 30-day SEC yield of 7.18%, while ANGL offers 6.87%.

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Institutional investors typically must sell bonds downgraded below investment grade by credit rating agencies such as Moody’s and Standard & Poor’s. This creates a supply-demand imbalance that temporarily depresses prices, explained Zachary Evens, manager research analyst at Morningstar. A 2019 report by the Chartered Alternative Investment Analyst Association found that bonds entering the Bloomberg Barclays US High Yield Fallen Angel 3% Capped Index are priced 150 basis points cheaper, on average, than their high-yield counterparts.

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This price drop presents an opportunity for investors. "Over time, as supply and demand rebalance, this price gap closes, leading to outperformance," Evens said.

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Both FALN and ANGL are part of Bank of America’s dynamic prudent yield strategy, which focuses on bonds with greater exposure to the real economy and less exposure to inflation and interest rate risks. According to Bank of America, this strategy has yielded better absolute and risk-adjusted returns in backtesting. So far this year, prudent yield sector ETFs have outperformed the U.S. Aggregate Bond Index by 3.5% and Treasurys by 9.3% on average, according to analyst Jared Woodard. Specifically, fallen angels are 3.2% above the 10-month moving average.

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The iShares Fallen Angels USD Bond ETF and VanEck Fallen Angel High Yield Bond ETF track different indexes. ANGL aims to replicate the ICE US Fallen Angel High Yield 10% Constrained Index, while FALN tracks the Bloomberg Barclays U.S. High Yield Fallen Angel 3% Capped Index. Stephen Laipply, global co-head of iShares fixed income ETFs at BlackRock, noted that FALN has traditionally outperformed both high-yield and investment-grade bonds over time.

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Historical data supports this: the Bloomberg Barclays U.S. High Yield Fallen Angel 3% Capped Index has annualized returns of 7.25% over the past 10 years, compared to 4.64% for the Bloomberg U.S. High Yield Index and 2.85% for the Bloomberg U.S. Corporate Bond Index, according to BlackRock.

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Despite their potential, fallen angel portfolios carry risks. They are generally higher quality than other high-yield bonds, with about 70% rated just below investment grade at BB, compared to 45% in the broader high-yield category, Evens said. However, there is always the risk of further downgrades. "If they were downgraded initially, the company's fundamentals might continue to deteriorate," Laipply warned.

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Conversely, about 25% of fallen angels eventually return to investment grade, he noted. These bonds also tend to have longer durations than other high-yield bonds, implying higher interest rate risk. FALN's current duration is 4.88 years, compared to 3.33 years for the iShares Broad USD High Yield Corporate Bond ETF (USHY).

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Evens argued that market dynamics and the short-term price collapse followed by appreciation are more critical to performance than duration and quality. "Historically, this has led to volatile performance despite the higher credit quality," he said, likening the volatility more to a low-volatility equity fund than a core-bond fund.

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During market corrections, fallen angels can experience sharp declines. For example, in 2020, fallen angel funds dropped more than core bond funds and even the broader high-yield category, Evens noted. Therefore, he suggests a modest allocation to fallen angels to enhance portfolio performance rather than a substantial one.

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