Cass Business School: academic analysis of investment opportunity of Fallen Angels phenomenon

The ‘fallen angels’ phenomenon can offer the opportunity to enhance the returns on a multi-asset portfolio and the potential to improve diversification, according to analysis from Cass Business School.

The paper “Fallen Angels: The investment opportunity”, written by Professors Andrew Clare, Stephen Thomas and Dr Nick Motson, and supported by Invesco PowerShares, is believed to be the first piece of academic analysis focusing specifically on the impact on bond prices of a downgrade from investment grade status to high yield status.

What is a fallen angel?
Some bonds in the high yield universe begin life as an investment grade bond, but due to a decline in the perceived credit quality of the issuer over time the bond may be downgraded to high yield status by credit rating agencies. The bonds of these issuers are referred to as fallen angels. A corporate fallen angel is one whose credit metrics no longer qualify it for investment grade status and the lower borrowing costs that come with that status.

What is the potential investment opportunity?
According to Cass, the potential investment opportunity exists because of a phenomenon known as the Overreaction Hypothesis. Psychologists have identified the tendency of people to overreact to bad news and underreact to good news1. In the mid-1980s research2 testing the overreaction hypothesis using US stock data found that stocks that had sold off heavily tended to rebound in a predictable way over subsequent months, often outperforming those stocks that had previously performed well. The results were so clear that the researchers showed how the phenomenon could be turned into an investment strategy involving buying losing stocks and short-selling winning stocks.

The possibility of a rebound
To investigate the phenomenon, Cass Business School analysed the price performance of 534 bonds over six years that had become fallen angels, 30 days before they fall from grace and for their first 30 days after the downgrade to high yield status3.

Andrew Clare, Professor of Asset Management at Cass Business School, commented: “We have found clear evidence that the bonds of issuers that have been downgraded to high yield status from investment grade status fell in price before the downgrade, and continued to fall for six to seven days on average after the downgrade. After this point we found that average prices rose for at least the post event window of thirty days that we study here.”

How could the fallen angel phenomenon fit into a portfolio?
Potentially benefitting from the fallen angels phenomenon is possible via index investing, according to the analysis. As an example, Citi has produced a fallen angel index which aims to track the performance of a universe of fallen angels3. The index is based upon the Citi US High-Yield Market Index, and has the same composition requirements regarding credit quality, maturity, and issue size.

As a way of exploring the possible ways of investing in a fallen angel’s universe Cass chose two ways of weighting a number of indices, in addition to the one by Citi: an index of US Treasuries (Treas); an index of US investment grade corporates (Corp); a high yield index (HY); and finally the Standard & Poor’s 500 Composite index (S&P)4.

First, the researchers applied an equal weight to the indices. The second approach involved weighting the indices such that the weighted volatilities of the indices were equal.

The results in the table “Equally-weighted combinations of asset classes” show that the addition of the fallen angel’s universe to the multi-asset class portfolio would have enhanced returns in all cases. The addition of the fallen angel’s index also produces a slightly higher Sharpe ratio in each case, which indicates that it might be possible to improve the risk-reward profile by adding an investment in fallen angels. Finally, the maximum drawdown is marginally higher with the addition of the fallen angel index, except when the fallen angel investment replaces the investment in US equities, as shown in the final column of the table.

The table below shows the risk and return characteristics of the same combinations of asset classes as analysed in the first table, but where the weights in each of the asset class combinations are risk parity-based rather than equally weighted.

With the exception of RP 4, which is a risk parity-based combination of Treas, Corp, HY and the S&P, all of these combinations achieved a lower average return over the sample period. However, in each case the maximum drawdowns were much lower. In this case, arguably, simply adding the Fallen Angel’s index to the other four produced the most attractive risk-return mix.

Professor Clare concluded: “The results of our analysis indicate that an investment in fallen angels, along the lines of the Citi Time-Weighted US Fallen Angel Bond Select Index, at a minimum gave an additional string to the diversification of a portfolio, but also offered the potential for enhanced risk-adjusted returns, however we choose to weight the multi-asset class components.”