Fallen Angel
A “fallen angel” is a term used in finance to describe a bond that was originally issued with an investment-grade rating but has since been downgraded to a junk bond. This downgrade typically occurs because of a decline in the issuer’s creditworthiness, often due to deteriorating financial performance or adverse economic conditions. Fallen angels are of particular interest to many investors because they may present opportunities for higher returns, albeit with increased risk.
Characteristics of Fallen Angels
Credit Rating
Initially, fallen angels possess an investment-grade credit rating from major credit rating agencies like Moody’s, Standard & Poor’s (S&P), or Fitch. However, after experiencing financial troubles, their credit ratings drop below the investment-grade threshold, generally below BBB- by S&P or Baa3 by Moody’s.
Issuer’s Financial Health
The issuer of a fallen angel bond often encounters financial difficulties such as declining revenue, increasing debt, or operational inefficiencies. These financial challenges cause rating agencies to reevaluate the creditworthiness of the issuer, leading to a downgrade.
Higher Yields
Fallen angels typically offer higher yields compared to bonds that maintain their investment-grade status. This is because investors demand higher compensation for the increased risk of potential default associated with lower-rated bonds.
Market Perception
Upon being downgraded to junk status, the market perception of a fallen angel changes dramatically. Investors who can only hold investment-grade securities are often forced to sell these bonds, which can lead to a sharp decline in their market prices. This sell-off might provide opportunities for other investors who specialize in distressed assets.
Causes of Downgrade
Several factors can lead to a bond being downgraded to fallen angel status:
Economic Conditions
Adverse macroeconomic conditions can significantly impact the revenue and profitability of a company. For instance, a recession can reduce consumer spending, causing revenue declines and financial strain.
Industry-specific Issues
Problems within a specific industry can affect multiple companies. For example, the collapse in oil prices around 2015–2016 resulted in several energy companies experiencing financial difficulties, leading to downgrades of their bonds.
Poor Management
Ineffective management decisions, such as poor strategic planning or financial mismanagement, can lead to deteriorating financial health and subsequent downgrades.
Leverage and Debt Levels
Companies with high levels of debt are particularly vulnerable to downgrades. If a company’s debt levels become unsustainable, its credit rating is likely to be downgraded.
Investment Strategies
Investors implement various strategies to capitalize on the opportunities presented by fallen angels:
Contrarian Investing
Contrarian investors look for fallen angels that they believe have been unfairly punished by the market. They purchase these bonds at depressed prices, anticipating a recovery in the issuer’s financial health and a potential upgrade in credit rating.
Distressed Debt Funds
Specialized funds focus on investing in distressed debt, including fallen angels. These funds employ expertise in evaluating the distressed assets and often engage actively with the management of the issuer to facilitate a turnaround.
Credit Risk Analysis
Sophisticated investors conduct thorough credit risk analysis to differentiate fallen angels with recovery potential from those likely to continue deteriorating. This involves assessing financial statements, industry conditions, management quality, and other qualitative factors.
Risks
Default Risk
The primary risk associated with fallen angels is default risk. If the issuer’s financial condition worsens, it may become unable to meet its debt obligations, leading to default.
Liquidity Risk
Fallen angels may suffer from reduced liquidity, especially after a downgrade, as investors might be unwilling to trade these lower-rated bonds. This can make it challenging to buy or sell these securities without affecting the market price.
Interest Rate Risk
Like all bonds, fallen angels are subject to interest rate risk. Rising interest rates can negatively impact bond prices, including those of fallen angels.
Notable Fallen Angels
General Electric (GE)
General Electric, once one of the largest and most successful companies in the world, experienced significant financial troubles in the late 2010s, leading to its bonds being downgraded closer to junk status. The downgrade was due to declining business segments, large debt burden, and operational challenges.
Kraft Heinz
Kraft Heinz saw its bonds downgraded to junk status as the company struggled with declining sales and substantial debt. The downgrade reflected the deteriorating financial metrics and challenges in turning around its business operations.
Recovery Stories
Delta Air Lines
Delta Air Lines faced severe financial difficulties and was downgraded to junk status in the early 2000s. However, the airline underwent a successful restructuring, improved its financial health, and eventually regained its investment-grade rating.
Ford Motor Company
Ford Motor Company’s bonds were downgraded to junk status during the financial crisis of 2008. The company managed to avoid bankruptcy, restructured its operations, improved profitability, and subsequently had its bonds upgraded back to investment-grade status.
Case Studies
Enron
Enron was once a high-flying energy company with investment-grade bonds. However, due to accounting fraud and unethical business practices, the company collapsed, and its bonds were downgraded to junk status. This case serves as a cautionary tale of how rapidly an investment-grade bond can turn into a fallen angel.
Lehman Brothers
Lehman Brothers was a prestigious investment bank whose bonds were rated investment-grade. The collapse of Lehman Brothers in 2008 due to exposure to subprime mortgages led to a downgrade to junk status and default, highlighting the systemic risk and rapid deterioration that can lead to the fallen angel status.
Resources for Investors
Investors interested in fallen angels can utilize various resources to stay informed:
Credit Rating Agencies
Monitoring reports and updates from credit rating agencies like Moody’s, Standard & Poor’s (S&P), and Fitch can provide valuable insights into potential fallen angels.
Financial News Outlets
Staying updated through financial news websites such as Bloomberg, Reuters, and CNBC can help investors identify companies facing financial difficulties that might lead to downgrades.
Specialized Research Firms
Research firms specializing in fixed income and distressed debt can offer detailed analysis and recommendations on fallen angels. Examples include:
Bond Market Platforms
Platforms like MarketAxess and Tradeweb provide access to bond market data, including pricing, liquidity, and trading information on fallen angels.
Conclusion
The phenomenon of fallen angels presents both opportunities and risks for investors. While these downgraded bonds offer higher yields, they come with increased credit risk. Understanding the causes of downgrades and employing strategies such as contrarian investing or distressed debt funds can help investors navigate this complex landscape. However, thorough credit risk analysis and awareness of potential risks are crucial in making informed investment decisions in the realm of fallen angels.