What are Fallen Angels?
Fallen angels are a type of bonds that are vested with an investment-grade rating and the same has been impacted as a result of the issuer’s financial condition and ultimately reduced to junk bond status and it can be municipal, corporate or even sovereign debt.
A bond that is now a Fallen Angels will often experience further declines as investors may pull out in anticipation of further downgrades. The compounded fall in the value can have grave repercussions eventually leading to possible rate cuts and a further level of declines. Additionally, it can have a downward spiral on the industry and cascading effects on the overall economy as well.
For instance, Moody’s assigned Company ‘Y’ an investment grade rating of ‘A’ indicating the firm is a high-quality firm with very low counterparty/default risk. Due to a major shift in the economic situation and mounting debt responsibilities, Company ‘Y’ experienced a massive decrease in their sales numbers for 3 consecutive quarters. This resulted in Moody’s downgrading Company Y’s credit rating to CCC i.e. junk bond status for speculative firms that could fail in its debt commitments. Thus, the bond of Company ‘Y’ will be considered as a ‘Fallen Angel’.
Characteristics of Fallen Angel
Some of the features of a Fallen Angels are:
- Susceptible to higher price volatility since there is a major shift in the status of the firm.
- Prior to an anticipated downgrade and index infusion, such bonds are sold off by the market in bulk quantities.
- Generally, post the downgrades it is possible that investors will rush to buy such bonds for speculative purposes. If the fundamentals are strong, there will be hopes of the firm recovering and earning high price returns.
In terms of statistics, Fallen angels compose around 4% of the market. As of 2016, some companies like Fossil Group and Symantec were on the brink of Junk Bond status.
Strategies Applicable for Recovery of Fallen Angels
The following strategies are applicable for recovery of Fallen Angels:
#1 – Change in Business Segments
A firm/entity may face a downgrade in the credit rating due to the below performance of specific segments of a business. A classic example is that of Nokia whereby the telecom equipment business generated higher revenues than the handheld devices segment. This was due to the shift in consumer preferences and technological advancements. Nokia was unable to generate adequate revenues from the business of handheld devices due to sophisticated competitors such as Apple and Microsoft entering the market.
The shares of Nokia turned out to be a Fallen Angels and they found it relatively hard to get back on track. The ideal option for such an entity is to sell or close the struggling division and divert the resources towards high-profit potential. A similar situation was applicable to Nokia whereby they had the opportunity to focus on improving the telecom equipment segment.
#2 – Expenditure Reduction
This is one of the less popular manners to get back on track but is a tactic adopted across the globe which includes:
- Limiting resources or terminating the services of employees whose services are less critical in the overall process.
- The firm may limit the resources by using superior or similar quality materials that cost lower than what the firm uses.
- Automating some of the processes can guide in reducing the number of resources attached to the support process/departments.
- Reducing/slashing benefits such as Healthcare or Pension until the business reaches a stage of recovery.
- Other strategies like Retrenchment or employing contractors can also be adopted.
#3- Changes in Capital Deployment
A firm/unit struggling with a situation of Fallen Angels can make changes to the process of Capital deployment by reducing the amount of capital allocated to underperforming segments and subsequently enhancing the allocations to the well-performing segments.
For e.g. AIG (American International Group) implemented such a strategy to remain stagnant post the financial crisis of 2008. This involved:
- Improving Capital allocation to the most productive segments for extending the base of revenues.
- Disposing of some of the assets for raising additional funds/capital.
- The funds were used to pay the Government bailout that was provided as part of the Government restructuring strategy for saving the US companies.
Risk and Opportunities of Fallen Angels
If a core level analysis is conducted, fallen angels do offer its share of pros and cons. Some of the associated risks with fallen angels are:
- The majority of the times a firm falling under this category is due to specific issues within the company or the industry it operates in. The macroeconomic situation has to be under control and the fundamentals of the firm should also be equally robust.
- The strategies adopted by the company should be in sync with the situations confronted. When issues arise from the internal struggles of the company, it is typically due to the usage of debt instruments for financing during an incorrect part of the development.
- The firm/industry may not be able to maintain pace with rising competition and technological advancement. Hence, it should keep on re-evaluating itself on a regular basis and adapt to the changing requirements.
- An inferior credit quality development of a bond will in most cases cause a decline in the price value and hence downward fluctuations in the value of a portfolio.
Despite various fallen angel risks, some of the opportunities offered are:
- If the downgrade is expected to be temporary in nature, investors can enter at purchasing them at a lower price.
- If the fundamentals of the firm are strong, they can offer the potential for much higher returns if held for some time.
Fallen Angels refer to a bond that was once attached with a High/Stable rating but due to some unfavorable circumstances, it has experienced a serious and sustained decline in the ratings and market demand.
Very often these fallen angel bonds have outperformed the original high-yield issues. For instance in 2015, in the European region, these bonds exceeded the high yield issue by around 3%. The returns from Fallen Angels were around 6% whereas the regular high-yield bonds offered around 3%.
While fallen angels have historically outperformed, the same should not be assumed. In 2010-11, they had underperformed due to subordinated bank debt and peripheral Eurozone bonds. While an influx of fallen-angel supply has the potential to boost long-term returns, fundamental research, including deep sector expertise, will always be critical in identifying the best of these firms to avoid unnecessary risk and make the most of the opportunity.
This has been a guide to Fallen Angels, its characteristics and recovery strategies. You may also have a look at these articles to learn more about Fixed Income.