Departures from Fallen Angels Could Belie Opportunity

Take it from someone that's been covering exchange traded funds for nearly 15 years. Inflows and outflows to and from various ETFs make for good headlines and, in a vacuum, are noteworthy.

However, inflows and outflows aren't investment advice, meaning these statistics aren't always harbingers of good or bad performance and should not be interpreted as such. As advisors that have been using ETFs for years know, there are myriad reasons why some ETFs see large arrivals and departures. For example, tech-driven investment models and model portfolios are active ETF market participants and can and do drive flows. Likewise, some professional traders may use a particular ETF as a hedge on a single stock trade.

I bring all this up because the reality is interpreting motivations for ETF flows often isn't worth the time. The second reason I'm mentioning this subject is because it's relevant right now to a specific corner of the fixed income market: Fallen angel bonds.

There are two ETFs dedicated to fallen angels. The VanEck Fallen Angel High Yield Bond ETF (NYSEARCA:ANGL) – the original and largest – and the iShares U.S. Fallen Angels USD Bond ETF (NYSEARCA:FALN). Data confirm last week investors pulled record amounts of cash from those funds as the Federal Reserve made it will likely start hiking interest rates in March.

Here, we'll explore why departures from fallen angel ETFs could be betraying opportunity with this asset class even as rates rise.

Fallen Angels Still Matter

For the uninitiated, and it's reasonable to expect many clients are in this group, fallen angels are bonds born with investment-grade ratings that are later downgraded to junk.

That's one marquee difference between these bonds and traditional high-yield and it's an important because it signals higher quality and better odds of being upgraded to investment-grade territory. Predictably, those factors often facilitate better performance relative to bonds born with the junk label. Speaking of performance...

“The fallen angels index outperformed the broad high yield index by 0.40% in December and by 2.36% for 2021 (7.72% vs 5.36%), making it the 14th year that fallen angels have outperformed broad high yield over the last 18 calendar years. The majority of the outperformance in 2021 came from the energy sector, where fallen angels are overweight the broad high yield index by more than 2x,” writes Nicolas Fonseca, VanEck associate portfolio manager.

Alright, we all know that past performance isn't an indicator of future returns, but fallen angels' consistency is something to behold. Add to that, fallen angels beat regular junk bonds in three of four quarters last year.

That's impressive when considering fallen angels usually have longer durations than traditional junk bonds. Remember, 10-year Treasury yields soared into the second quarter and regained some momentum late in 2021 as it became clear 2022 would be a year of rate hikes.

Speaking of Interest Rate Policy...

If Fed tightening is the primary reason for the aforementioned departures from fallen angel ETFs, those outflows could prove to be hasty because this asset class has durability during tightening regimes.

“Interest rate movements, historically, have not been a primary driver of long-term outperformance relative to the broader market and that was true again last year. In fact, fallen angels came out on top of the broad HY despite the 10Y rising 0.59%,” adds Fonseca.

Consider the performance of fallen angels during the prior two eras of earnest interest rate increases. Combine that with the income proposition offered by these bonds and advisors could be onto something to discuss with yield-hungry clients.

From the “middle of 2004 to middle of 2006: Fed Funds were raised from ~1% to ~5.25% and the fallen angels outperformed by 1.59% (18.65% vs 17.06%),” notes Fonseca. “From October 2015 to January 2019: Fed Funds were raised from ~0% to ~2.5% and the fallen angels outperformed by 8.93% (31.87% vs 22.94%).”

Related: Dividends Provide Reason for Equity Optimism