What Is a Fallen Angel?
A fallen angel is a bond that was originally rated investment grade but has since been downgraded to non‑investment grade (junk) by a major credit rating agency (for example, S&P, Fitch, or Moody’s). Downgrades typically reflect a deterioration in the issuer’s financial condition — declining revenues, rising leverage, or other stresses that increase default risk. The term is also sometimes used informally for stocks that have dropped sharply from prior highs.
Key points (quick view)
– Fallen angel = formerly investment‑grade bond downgraded to high‑yield/junk.
– Causes: sustained revenue declines, higher debt, weakening cash flow, or adverse events.
– Effects: forced selling by investment‑grade‑only investors, price declines, yield spikes.
– Opportunity: can offer higher yields if the issuer has a credible path to recovery.
– Risks: some fallen angels never recover and default; liquidity and sector concentration can be problems.
How downgrades happen
– Watchlist/credit watch: A ratings agency may first place debt on negative watch or outlook when it sees deteriorating fundamentals. That often triggers early selling.
– Formal downgrade: If conditions worsen or fail to improve, the issuer’s rating is cut to junk. Many institutional investors and funds that must hold only investment‑grade debt are forced to sell.
– Market reaction: Forced sales and reduced demand push prices down and yields up. The larger the forced selling (e.g., from funds with strict mandates), the steeper the price reaction can be.
Why investors look at fallen angels
– Potential bargain pricing: Sellers forced by mandates often accept steep discounts; buyers who believe the downgrade reflects temporary problems can capture higher yields and price appreciation if the issuer recovers.
– Improved yield per unit of credit quality compared with stable peers.
– Diversification and active alpha opportunities for managers who can perform issuer‑level credit work.
Types of issuers
– Corporates: Common examples — companies hit by industry cycles (energy, retail, autos), temporary operational setbacks, or higher leverage from acquisitions.
– Municipalities: Cities or states with declining tax revenue and rising pension/debt burdens can be downgraded to junk.
– Sovereigns: Countries with fiscal stress or sudden economic shock may be downgraded.
– Fallen angel stocks: Separate concept — stocks that have fallen far from prior highs, sometimes reflect business decline.
Risks of investing in fallen angels
– Permanent impairment/default: Some issuers never recover; revenue declines can be structural (technology disruption, loss of market).
– Liquidity risk: Lower ratings often mean thinner trading and wider bid‑ask spreads.
– Concentration risk: Fallen angels may cluster in stressed sectors (e.g., energy), increasing correlated downside.
– Event risk: Bankruptcy restructuring can wipe out bondholders or materially change recovery expectations.
– Rating‑agency lag and unexpected downgrades: Agencies can change ratings quickly based on new information.
– Interest‑rate and call risks: Prices remain sensitive to rates; some bonds may be callable or have other features that affect returns.
– Tax and account rules: Some funds and accounts have rules limiting exposure to non‑investment grade securities.
Practical steps for evaluating and investing in fallen angels
This step‑by‑step checklist is designed for individual investors or advisors evaluating a fallen‑angel bond or a fund that invests in them. It is not investment advice — consider your own risk tolerance and consult a financial professional.
1) Start with the downgrade: read the ratings action and rationale
– Read the rating agency’s downgrade notice and watch/outlook comments (S&P, Moody’s, Fitch). Understand the specific reasons cited (revenue, leverage, liquidity, covenants, legal issues).
2) Identify the root causes and time horizon
– Are the problems cyclical (commodity price declines, recession) or structural (loss of market share, obsolete product)?
– Assess whether the issuer has plausible, time‑bound catalysts for recovery (price rebound, cost cuts, asset sales, refinancing).
3) Review fundamentals and cash flow
– Look at most recent financial statements: revenues, EBITDA, operating cash flow, free cash flow, debt maturities, liquidity (cash and committed credit lines).
– Check leverage ratios (debt/EBITDA), interest coverage, and upcoming maturities that could force refinancing.
4) Consider capital structure and seniority
– Determine where the bond sits in the capital structure (senior secured, unsecured, subordinated). Senior secured debt generally recovers more value in distress.
– Check covenants and any cross‑default triggers.
5) Compare market pricing and yields
– Compare the bond’s yield spread to comparable issuers and the issuer’s other debt. A larger spread may reflect either opportunity or more severe credit risk.
– Look at credit default swap (CDS) spreads for market view on default probability (if available).
6) Evaluate liquidity and trading history
– Check recent trading volumes and bid/ask spreads. Thin liquidity can make it hard to exit a position without large price impact.
7) Think about recovery scenarios
– Build a base case, upside, and downside scenario: what would default look like, and what recovery might bondholders receive? How likely is each outcome?
– Consider whether the market has already priced in the worst case.
8) Decide on sizing and portfolio impact
– Limit position size relative to portfolio so a negative idiosyncratic outcome won’t overwhelm diversification.
– Consider sector concentration and correlation with other holdings.
9) Use funds or ETFs if you lack credit resources
– If you don’t have the time or expertise for issuer‑level credit work, consider specialized ETFs or mutual funds that focus on fallen angels (example: VanEck Vectors Fallen Angel High Yield Bond ETF; iShares Fallen Angels USD Bond ETF). These pool credit research and diversification but have management fees and active risks.
– Check fund mandates, turnover, and historical performance, and note holdings and sector exposure.
10) Monitor actively after purchase
– Watch news, earnings, covenant compliance, and rating agency updates. Fallen angels require closer monitoring than stable investment‑grade bonds.
Investment strategies that use fallen angels
– Contrarian buy-and-hold: Buy bonds you judge to be temporarily mispriced and hold through recovery.
– Trading/arbitrage: Shorter‑term trades around technical selling pressure (watchlist/downgrade windows).
– Active credit selection: Focus on senior secured bonds or issuers with strong asset coverage.
– Fund/ETF exposure: Gain diversified exposure to a basket of fallen angels without single‑issuer risk.
When to prefer funds/ETFs vs. individual bonds
– Prefer funds/ETFs if:
– You lack time/expertise to analyze issuer credit.
– You want instant diversification across many fallen angels.
– You prefer liquidity of an exchange‑traded vehicle.
– Prefer individual bonds if:
– You can do deep credit work and identify mispriced single names.
– You want to target specific maturities, covenants, or seniority.
– You wish to control tax lots and holding periods.
Examples and common scenarios
– Cyclical industry (oil example): An oil company sees sustained losses during a prolonged low‑price environment. Its bond rating drops from investment grade to junk; yields rise and price falls. Contrarian buyers who believe oil prices will recover may buy the bonds if debt maturities and liquidity appear manageable.
– Structural decline (technology disruption): A company loses market share to new technology; downgrade reflects permanent revenue loss. These fallen angels are less likely to recover.
– Municipal stress: A city with shrinking tax base and rising pension obligations can see investment‑grade muni bonds downgraded toward junk; chronic fiscal stress raises default risk.
Portfolio risk management and exit planning
– Set stop‑loss or review thresholds and predetermined scenarios that would trigger selling or further analysis.
– Maintain position limits for any single issuer and sector.
– Have an exit plan: do you sell on further downgrades, price levels, or deteriorating liquidity?
– Consider hedging via CDS or other instruments where available and cost‑effective.
Who should consider fallen angels?
– Experienced income investors or credit specialists who can analyze issuer fundamentals.
– Contrarian investors willing to accept high default risk for higher yield.
– Investors seeking diversification into high‑yield space via specialized funds/ETFs.
– Not generally suitable for investors who need capital preservation or low volatility.
Key takeaways
– Fallen angels can offer attractive yields if the downgrade reflects temporary problems and the issuer has a credible recovery path.
– They involve elevated credit, liquidity, and concentration risks — some fallen angels never recover.
– Careful credit analysis, position sizing, diversification, and active monitoring are essential.
– If you lack expertise, consider dedicated fallen‑angel funds or ETFs, but review their strategy, fees, and holdings.
Sources and further reading
– Investopedia. “Fallen Angel.” https://www.investopedia.com/terms/f/fallenangel.asp
– VanEck. “VanEck Fallen Angel High Yield Bond ETF.” (accessed Sept. 13, 2021)
– iShares. “iShares Fallen Angels USD Bond ETF.” (accessed Sept. 13, 2021)
Important: This article is informational and educational. It is not investment advice. Consult a qualified financial advisor or credit analyst before making investment decisions.