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Fallen Angel Bonds: Will Their Heavenly Rally Last?

Investors have gobbled up downgraded debt, much of it in battered commodity producers. But that play could fizzle if low prices persist.

Fallen angel bonds have soared over the past three months, extending their trend of outperformance over more conventional high-yield bonds. But market participants say that the bull run may end soon, as the woes facing commodity-related companies persist.

Fallen angel bonds are formerly investment-grade debt instruments that have been downgraded to high-yield. JPMorgan Chase & Co. analysts estimate that some $140 billion of bonds attained fallen angel status in the first quarter, much of that sparked by the commodity price plunge. A total of 20 of 26 fallen angels in the quarter consisted of energy, metals and mining companies.

Investors have found a number of those bonds attractive. “We’ve dabbled in some of the energy names in low triple-B or double-B that have made major changes in their capital structure, so they look like they will survive,” says Michael Collins, co-manager of the Prudential Total Return Bond Fund in Newark, New Jersey.

Many commodity-related companies have restructured their cost profiles and balance sheets, are paying back debt and cutting dividends, making the bonds appealing. Among the fallen angels drawing strong investor interest are Phoenix-based mining company Freeport-McMoRan and Calgary, Canada’s integrated oil company Cenovus Energy.

The Bank of America Merrill Lynch U.S. Fallen Angel High Yield index generated a torrid return of 11.84 percent for the year-to-date through May 12. Over the first four months of 2016, the index outperformed BofA’s broader U.S. High Yield index by more than 5.5 percentage points.

Looking back a bit farther, the Fallen Angel index’s return exceeded that of the broader index by 2.5 percentage points annualized for 2011-’15, with 10 percent less volatility.

The dynamic with these bonds is that when investment-grade companies with a lot of debt get downgraded to junk, many investment-grade bond fund managers have rules forcing them to unload the paper. Massive forced selling ensues, and prices drop below fundamental value, Collins says.

But the fallen angels, which don’t want debt with an 8 percent yield, are very motivated to return to investment-grade status. The companies are often big ones with diversified assets they can sell to avoid bankruptcy. Meanwhile, banks will often cater to fallen angels because they are long-standing customers. “So fallen angels have a higher survival rate than your average high-yield company,” Collins says.

In recent months, the onslaught of commodity-related fallen angels has put fear back into the market, says Oleg Melentyev, the New York–based head of U.S. credit strategy for Deutsche Bank. And investors don’t know how much additional supply will come to the market.

Bond fund managers have exposure limits for individual sectors, which were quickly filled for energy, mining and metals. More bonds came to the market than investors were willing to buy, sparking large price markdowns. “Couple that with the rebound in commodity prices, and you have all the ingredients for a very nice pop in those bonds,” Melentyev says. But he and others aren’t sure that pop will last.

That’s largely because the recovery in fallen angel bonds is highly correlated to rising commodity prices. “If you think that’s going to continue, you can continue to fish in this pool,” says Bruce Falbaum, senior portfolio manager of Cohanzick Management in Pleasantville, New York. “But you’re making a bet, and I’m not willing to make that bet.” Other assets offer better return possibilities, including stocks and junk bonds outside the commodity sector, he says.

Melentyev says downgrades of commodity companies may persist, pointing out that rating agencies often take their time in making negative decisions. And there are plenty of triple-B-rated commodity companies. “The greatest risk of buying fallen angels is you’re trying to catch the falling knife,” he says. “Some companies may be downgraded to double-B first, then single-B, then triple-C, then may default.”

Falbaum likes some high-yield bonds outside the commodity sector that have been hurt by the market’s overall downdraft earlier this year, including fallen angel New York’s Icahn Enterprises and boiler manufacturer Cleaver-Brooks, based in Thomasville, Georgia. “We think a lot of bonds that were damaged are perfectly good credits,” he says, adding that he sees plenty of opportunities in the single-B and triple-C spaces, particularly among small issuers, outside the energy sector.

For the long term, the inherent inefficiencies of the market probably bode well for future fallen angels, Collins says. But the current class already has enjoyed a strong rebound, so this may not be a good time to buy, he and others say.

“This is more an area we’re watching to see if there’s a decline, so we would have an opportunity to look at more attractive levels,” says Richard Inzunza, director of high-yield taxable fixed income at Northern Trust in Chicago.

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