Bad Debt Ratings Make Great Opportunities

Bad Debt Ratings Make Great Opportunities

over 3 years ago2 mins

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What’s going on here?

Credit rating agencies regularly scrutinize companies’ bonds, scoring them on the likelihood of the debt being repaid. Those deemed safe enough bets for mainstream investors are classed as “investment-grade” – while those carrying a greater level of risk are designated “high-yield” or “junk” bonds.

A record number of companies have had their debt ratings downgraded this year; perhaps unsurprisingly, given the financial strain of coronavirus. Those dropped into junk territory are known as “fallen angels” – and the roll call of casualties locked out of heaven includes high-profile names like Kraft Heinz, Ford, Delta Air Lines, and Marks & Spencer 👿

What does this mean?

Unlike Lucifer, these companies aren’t necessarily consigned to the flames. In fact, the most recently downgraded companies' bond prices tend to outperform their new high-yield peers over time.

Average bond price performance in the days before and after a fall from grace
Average bond price performance in the days before and after a fall from grace

That’s partly because forward-looking investors often sell off bonds in anticipation of a downgrade, while others buy back in once the dust has settled. After all, the vast majority of junk bonds (especially borderline ones) will still get repaid – and since a company’s got to be pretty stable to be considered investment-grade in the first place, they may end up bumped up again before too long.

The upshot? Fallen angels have delivered higher (and, crucially, higher risk-adjusted) returns than other junk bonds in 12 of the last 16 years 😇

Why should I care?

While personal circumstances vary, a balanced investment portfolio typically includes a certain proportion in bonds as well as stocks and cash. And particularly given the scant returns on offer elsewhere in the bond market, fallen angels could well merit inclusion.

That’s especially true if you’re a long-term investor. Since fallen angels’ prices can often behave more like volatile stocks than stable government bonds, shifts in investor sentiment may lead to rapid short-term sell-offs – even if they later outperform…

In fallen angels’ favor, though:

1️⃣ Current average yields of 5% offer a better return than putting cash in the bank or government bonds.

2️⃣ Sectors hit hardest by coronavirus, such as energy and transport, feature the greatest number of fallen angels. As the world recovers from the pandemic, their fortunes (and bond prices) should improve.

3️⃣ Former investment-grade status may make them a less risky investment than bonds that’ve been junk since day one 🙏

Since direct investment in junk bonds isn’t open to most investors, perhaps the simplest way to take advantage of the opportunity is via exchange-traded funds (ETFs). The ANGL ETF, for example, tracks the performance of US fallen angels – and since 2012, it’s outperformed high-yield bond benchmarks by 2.8% per year.

The ANGL ETF has delivered superior returns in recent years
The ANGL ETF has delivered superior returns in recent years
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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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