Generating investment alpha is hard. Taking an active trading decision of any size means you are necessarily betting against a smart, well-informed, and motivated professional on the other side of your trade. To consistently outperform the market, you need to be right more often than your counterparty.
One way to do this is to know more, have better information, or just be smarter. Another option is to try to buy assets from forced sellers. One such opportunity is in so-called fallen angel bonds.
Many investment funds have limits restricting their holding of non-investment-grade bonds, which may lead to a situation where a fund is forced to sell a bond that was previously investment-grade but has recently been downgraded. The theory states that buying these bonds may present an opportunity to buy at a lower price than their fair value as the seller is forced to execute their trade.
Of course, you are not the only buyer in the market, and this is a well-known idea, so even if the seller is forced to sell, many other buyers may be competing for this same opportunity and eroding any excess returns.
To test this, we have plotted the historic volatility vs. return of a series of US corporate bond indices published by the Bank of America. These indices track the return of baskets of bonds based on their credit ratings.
Finance theory dictates that these indices should sit on a straight line when plotted on a risk vs. return plot. The lower the credit rating of the index, the higher we expect its volatility (as a proxy for risk) to be, and the higher the return that the market expects to earn to be compensated for that risk.
Investment grade is considered any issue rated BBB and above, so we are particularly interested in the performance of the BB index, as this is where the ‘fallen angels’ would reside.
Source: ICE BofA
We present this data over four different time periods and notice a few things. Firstly, the longer the period of history that we measure over, the closer the result is to what theory would predict.
Most importantly, though, in each period we measure, the BB basket has generated a higher risk per unit of volatility than any of the other indices, showing that the fallen angel effect has indeed been present and that investing in those bonds just below investment grade has been the best risk-adjusted strategy within this universe.
Finally, it is also interesting that this result holds over the past 5 and 10 years and not just over the long term. Many results such as this may have been profitable in the past, but their effectiveness wanes as they are widely known, and any advantage competed away. It seems like this has not been the case here.
Our global multi-asset class mandates all hold a strategic asset allocation to high-yield bonds, and while we currently believe that the asset class offers very little value due to low credit spreads and are hence underweight, we do think that a long-term strategic tilt towards BB credit (mandate permitting), to take advantage of the above phenomena, makes sense in a multi-asset portfolio.
Our Market Snippets aim to provide concise insight into our investment research process. Each week, we highlight one chart that showcases our research, motivates our current positioning, or simply presents something interesting we’ve discovered in global financial markets.
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