An Angelic Approach to Help Clients Deal with Rising Treasury Yields

My survey isn't scientific, but going out on a limb here, it's probably safe to say many advisors would describe the current fixed income environment as “trying.”

That and we're not even four full months into 2021. Those are the breaks when 10-year Treasury yields more than double in less than nine months as is the case today. Undoubtedly, that means some clients may want to stretch for yield, taking on too much risk in the process.

Fortunately, the current climate isn't proving dreadful for high-yield corporate bonds. The Markit iBoxx USD Liquid High Yield Index is basically flat year-to-date. Combine that with ample Federal Reserve liquidity and stimulus and a still tricky income environment and some clients may be compelled to take on the junkiest of junk credits, such as CCC-rated bonds.

Opportunity beckons for both advisors and clients because the former can highlight value to the latter by discussing fallen angel bonds. An easy way of explaining fallen angels to clients is that these are bonds that were bonds born with investment-grade ratings only to later be downgraded to junk. Sounds ominous, but the opposite is actually true.

Useful Today, Useful for Awhile

Relative to traditional junk bonds, fallen angels are a smaller though mostly liquid slice of the expansive corporate debt universe. For whatever reason, fallen angels don't get press (or the monetary allocations) on par with their traditional high-yield counterparts.

The lack of attention belies the advantages and higher quality associated with fallen angels. On those fronts, all the ICE US Fallen Angel High Yield 10% Constrained Index – a widely followed fallen angel gauge – has outperformed standard junk bonds, often by wide margins, in 12 of the past 16 years. Some of that out-performance is attributable to higher quality, meaning fallen angels tend to sport higher credit ratings than bonds born as junk. That can also mean better risk/reward for clients.

All those fine attributes are worth considering today because fallen angels historically perform well when interest rates rise.

“While rising rates are generally negative for rate sensitive asset classes like fallen angel high yield bonds, the reason behind the latest rate moves may provide support for fallen angels,” according to VanEck research. “Historically, the fallen angels index  has provided positive returns and outperformance vs the broad high yield index in most rising rate periods. Higher rates reflect expectations for stronger growth, which is generally positive for high yield bonds. The fallen angels index, in particular, may benefit due to a higher weight towards economically sensitive sectors which may have stronger participation in the ongoing economic recovery.”

Quality Matters

Owing to longer duration, fallen angels scuffled a bit in the first quarter. The upside of fallen angels' longer duration is a 4.70% yield on the ICE US Fallen Angel High Yield 10% Constrained Index. That's just 16 basis points below the Markit iBoxx USD Liquid High Yield Index and that's a great trade-off for clients when considering the aforementioned quality proposition offered by fallen angels.

“Fallen angel bonds continue to provide a heavy tilt towards higher quality high yield bonds. At quarter-end, 94% of fallen angels were rated BB, the highest rating category within high yield,” notes VanEck. “Lower rated bonds, however, performed best in Q1 as investors prepared for the economy to get back on track. These bonds usually pay higher coupons, which offer some protection against rising yields. They are also favorable when expectations for growth is high as defaults tend to be low.”

That quality opens fallen angels to a broader client place – even risk-tolerant retirees – and as Treasury yields normalize, fallen angels are also suitable for younger clients that can take on more risk than is offered by basis aggregate bond funds. Advisors helping clients understand fallen angels may themselves be awarded metaphorical halos.

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