Stock Performance of Fallen Angels Post Federal Reserve Rate Cuts
In the midst of high volatility, elevated valuations, and concerns about economic growth, the case for higher quality exposure is gaining traction among high yield investors. Fallen angels, represented by the ICE US Fallen Angel High Yield 10% Constrained Index (H0CF), outperformed broad high yield, as represented by the ICE BofA US High Yield Index (H0A0), by 19bps in July, with a return of 2.15% compared to 1.96%. This performance narrowed the year-to-date underperformance of fallen angels to 1.37%, with returns of 3.26% versus 4.63%.
The divergence between fallen angels and broad high yield became more pronounced towards the end of the month, particularly on the day of the Federal Reserve meeting. The Fed decided to leave rates unchanged but signaled confidence in disinflationary trends, leading the market to interpret the stance as dovish and increasing the implied probability of a rate cut in September. Consequently, long-term Treasury yields gradually decreased throughout the month, favoring longer duration assets and contributing to fallen angels’ outperformance.
However, concerns grew towards the end of the month as high yield bond spreads began widening, reflecting apprehensions about a potential economic slowdown or recession. Weak economic data, especially related to employment, further fueled these concerns and resulted in a significant decline in bond yields along with a widening of credit spreads. While the market grapples with the possibility of a recession and a broader credit spread widening cycle, it is worth noting that high yield bond spreads remain below their 10-year average despite recent increases.
The likelihood of a September rate cut by the Federal Reserve has significantly risen in recent days, prompting investors to assess the historical performance of fallen angels and broad high yield bonds during previous rate-cutting cycles. Analyzing periods from September 2007 and August 2019 when the Fed lowered rates, fallen angels consistently outperformed broad high yield in the aftermath of the first rate reduction. This trend suggests that higher quality and differentiated sector exposure in fallen angels may drive future outperformance, as seen in past rate-cut cycles.
Examining performance from the last hike to the first cut and from the last hike to the last cut further underscores fallen angels’ outperformance. In both scenarios, fallen angels surpassed broad high yield by an average of 0.80%. Notably, fallen angels delivered double-digit returns in the period from the last hike to the first cut, outpacing broad high yield by 0.71% on average. Conversely, broad high yield posted negative returns in the period from the last hike to the last cut, while fallen angels achieved positive returns.
Fallen angels’ statistics in July point to a favorable trend, with yields declining to 6.81%, the lowest level this year, and prices reaching $91.90, the highest since February 2023. Broad high yield also experienced similar changes, with yields decreasing by 33bps and prices increasing to $94.37. The movement in yields and prices reflected a rally in the 10-year U.S. Treasury yield, which ended the month at 4.09%.
In terms of sector performance within fallen angels, the exit of Delta Air Lines from the index reduced exposure to the Transportation sector to 1.10%. Energy, Retail, and Telecom sectors saw slight increases in weights, while all sectors except Retail, which holds the largest exposure at 19.39%, posted positive returns in July. Telecom and Real Estate sectors were the top performers, with both sectors contributing to fallen angels’ outperformance. Comparing sector performance between fallen angels and broad high yield, Telecom and Real Estate emerged as the top contributors to outperformance, with fallen angels overweighted in these sectors and still delivering higher returns.
Rating exposure within fallen angels remained stable, with BB-rated bonds dominating the index at approximately 87% exposure. The higher quality of fallen angels offers an attractive proposition for investors seeking higher yields and lower volatility, as broad high yield exposure to BB-rated bonds stands at just 53%. Despite the presence of CCC and CC rated issuers in fallen angels, these lower-rated bonds outperformed their higher-rated counterparts. However, BB-rated bonds were the primary contributors to July’s outperformance, with a standout return of +120% in Embarq Corporation, the only issuer rated CC.
In conclusion, the performance of fallen angels post Federal Reserve rate cuts showcases the resilience and potential outperformance of higher quality bonds in the high yield space. As market conditions evolve and the likelihood of a rate cut looms, investors may find value in exploring fallen angels for their historical track record of outperformance and differentiated sector exposure. With ongoing economic uncertainties and market volatility, the case for higher quality exposure remains compelling for high yield investors seeking to navigate shifting market dynamics.
