Photographer: Jason Alden

Help! These Fallen Angels Have Fallen and They Can't Get Up

The population of fallen angels—or corporate bonds that were once rated investment grade but have since come plummeting down to junk-rated territory—has been swelling in recent months

Stubbornly low oil prices that have tipped some formerly investment grade-rated energy companies into high-yield territory are responsible for most of the downgrades, with fallen angels now comprising $22 billion of the $52 billion in securities eligible to join the Bloomberg Global High Yield Corporate Bond Index this month. 

Fallen angels are not unusual in the corporate bond market and they tend to follow a well-trodden pattern. Before the 'fall' comes underperformance when measured against their investment-grade peers. Once the downgrade occurs, fallen angels tend to outperform their junk-rated brethren. However, this dynamic has been exacerbated of late; fallen angels have declined precipitously and then soared in a heavenly arc.

Citigroup Inc. analysts led by Stephen Anzak point out the dynamic in a note published on Friday:

"The recent cohort of fallen angels (we define recent as names that fell in the second half of 2015 onwards) also underperformed [BB-rated corporate bond comparisons] in the months preceding their fall into high-yield, and reversed course soon after their downgrade. So in that context, more-or-less normal results.

But the degree of the movements was very unusual — the underperformance compared to the double-B index of the recent downgrades was over four times what we have historically seen. The atypical magnitude is primarily attributable to the fact that most of the recent falling angels were energy names. If we exclude the energy names from our sample set we see that performance is by and large normal."

Source: C
Source: Citigroup

Not all bond moves are created equal, however, even heavenly ones.

The V-shaped recovery shown above disguises a wide range in performance. Energy companies that were downgraded in February, for instance, have noticeably lagged energy firms that were cut in January.

February's downgrades posted average cumulative returns of -38 percent in the six months before their respective ratings cut, and have recovered only a third of that loss since. By contrast, energy companies that were downgraded in January have recovered 80 percent of their pre-downgrade loss in the same time period.

fallen2
Source: Citigroup

The divergence in celestial fate may say something about the sheer exhaustion of credit traders in February, when worries over global growth weighed heavily on most asset classes. Alternatively, they may indicate a wariness when it comes to specific corporate credits. 

Companies that have lagged include Diamond Offshore Drilling Inc., Ensco Plc, and Noble Holdings International Ltd.

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