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Fallen angel ETFs with yields of around 7% have exceeded expectations, but also come with risks

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Investors looking to diversify their bond portfolio may want to consider fallen angels, a segment of the market that is often overlooked but has been outperforming recently. Fallen angels are bonds that have been downgraded from investment grade to high yield by credit rating agencies. Two exchange-traded funds that invest in fallen angels are the iShares Fallen Angels USD Bond ETF (FALN) and the VanEck Fallen Angel High Yield Bond ETF (ANGL). These bonds are often sold by institutional investors due to the downgrade, causing an imbalance in supply and demand that can create opportunities for investors. Fallen angels have historically outperformed high-yield and investment-grade bonds over time, making them an attractive option for those seeking higher returns.

The Bank of America’s dynamic prudent yield strategy includes fallen angels as part of its portfolio, focusing on bonds with exposure to the real economy and lower risks from inflation and interest rates. This strategy has shown better backtested absolute and risk-adjusted returns compared to other bond indexes. Fallen angels, specifically, have been performing 3.2% above the 10-month moving average, indicating their potential for outperformance. Both FALN and ANGL track different indexes, with FALN traditionally outperforming high yield and investment grade bonds. Historical data show that fallen angels have annualized returns of 7.25% over the past 10 years, higher than high yield and investment-grade bonds.

While fallen angels may offer higher-quality bonds compared to high-yield peers, there are still risks involved. Approximately 70% of fallen angels are rated just below investment grade at BB, making them susceptible to further credit downgrades. Additionally, fallen angels tend to have longer durations than high-yield bonds, exposing investors to interest rate risk. Despite higher credit quality, fallen angels can be more volatile than core bond funds, especially during market corrections. In 2020, fallen angel funds experienced larger declines compared to core bond funds and the broader high-yield category. Investors should consider a small allocation to fallen angels in their portfolio to enhance returns, rather than a significant investment that could lead to unwanted surprises during market fluctuations.

Overall, fallen angels can be a valuable addition to a diversified bond portfolio, offering potential for higher returns compared to high-yield and investment-grade bonds. These bonds benefit from an imbalance in supply and demand following a downgrade, allowing investors to capitalize on price discrepancies. While fallen angels carry risks such as further credit downgrades and duration exposure, their historical performance suggests they can provide a boost to overall portfolio returns. By understanding the unique characteristics of fallen angel bonds and their market dynamics, investors can make informed decisions about including them in their investment strategy.

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