Fallen Angel

Fallen Angel: Definition and Overview

A fallen angel is a bond that was originally rated investment grade but has been downgraded to junk (non‑investment grade) after a deterioration in the issuer’s creditworthiness. Downgrades can affect corporate, municipal, or sovereign debt. The term is also sometimes used more loosely to describe stocks that have fallen sharply from their highs.

How Downgrades Happen

• Credit rating agencies such as Standard & Poor’s, Moody’s, and Fitch lower ratings when an issuer’s financial condition weakens.
• The most common triggers are sustained declines in revenues and rising debt levels, which increase default risk.
• A downgrade process often begins with a placement on negative credit watch. That signal alone can force mandated sellers (funds and managers restricted to investment‑grade debt) to exit positions.

Market Consequences

• Mandatory or forced selling by investment‑grade funds and other constrained investors increases supply and drives bond prices down.
• Lower prices push yields higher, which can make fallen angels attractive to investors willing to accept higher credit risk.
• Selling pressure is typically greatest immediately after the downgrade; price recovery depends on whether the issuer’s underlying problems are temporary or structural.

Fallen‑Angel Funds and ETFs

Some bond funds and ETFs specialize in buying fallen angels, giving investors targeted exposure to this niche:
– Examples include the VanEck Fallen Angel High Yield Bond ETF and the iShares Fallen Angels USD Bond ETF, which focus on bonds that have been downgraded to high yield.

Risks to Consider

• Credit risk: A downgrade reflects increased probability of default. Some fallen angels never regain investment‑grade status and may default.
• Sector and structural risk: If an issuer’s decline is due to permanent changes (e.g., technological obsolescence or disruptive competition), recovery is unlikely.
• Liquidity risk: Distressed bonds can trade thinly, amplifying price volatility and execution risk.
• Concentration and policy risk: Municipal or sovereign issuers with declining tax revenues and rising debt can spiral toward default, affecting many bondholders.

Illustrative examples:
– An oil producer suffering multi‑quarter losses from low commodity prices may be downgraded; if low prices are temporary, bonds might recover, but prolonged disruption could prevent recovery.
– Municipalities with shrinking revenue bases and rising obligations can see their debt downgraded and become unable to meet payments.

How Investors Evaluate Fallen Angels

When considering fallen angels, assess:
– Whether the downgrade stems from a temporary shock or a long‑term structural problem.
– The issuer’s business fundamentals, cash flow and debt servicing capacity.
– Recovery catalysts (e.g., management changes, asset sales, favorable industry trends).
– Liquidity and diversification; many investors prefer actively managed funds that can research individual credits.

Key Takeaways

• A fallen angel is a bond downgraded from investment grade to junk due to weakening issuer credit.
• Downgrades often trigger forced selling, depressing prices and raising yields.
• Fallen angels can offer higher yields and potential upside if an issuer recovers, but they carry greater default, liquidity, and sector risks.
• Careful credit analysis, diversification, and an understanding of whether problems are temporary or structural are essential when investing in fallen angels.