By Ermira Marika and Nithin Mallya, Pictet Asset Management.
Recent market shocks—particularly the tariff measures introduced by the Trump administration—have significantly unsettled the global credit bond landscape. Higher inflation expectations have driven government bond yields upward, while fears over corporate earnings have widened credit spreads. But amid this volatility lies a compelling opportunity for European high yield credit investors, particularly through a phenomenon known as “fallen angels.”
Fallen angels are bonds that have been downgraded from investment grade to high yield. While the downgrade itself may seem negative, history shows that these bonds can generate strong returns for those who invest strategically. According to historical performance data, buying these bonds shortly after their downgrade can yield excess returns of 3.1 percentage points over one year and 4.5 percentage points over two years, relative to their high yield peers.
This return potential stems from the mechanics of the downgrade process. Bonds flagged for possible downgrade typically begin to trade at a discount as investor sentiment turns cautious. When the downgrade becomes official, many institutional investors—restricted by mandates that prevent holding sub-investment grade assets—become forced sellers, driving prices down further. The high yield market, being smaller in size than the investment grade market, struggles to absorb this sudden influx, which amplifies the spread premium.
At this stage, fallen angels offer highly attractive entry points for high yield investors. As the market adjusts and re-prices these bonds in line with their new peer group, spreads tighten, and prices recover—often within twelve months—leading to outperformance.
However, not all fallen angels perform equally. While three-quarters either outperform or match their new high yield benchmarks, the worst-performing segment—around the bottom 5-10%—can severely drag on returns. Avoiding these underperformers is key to maximizing gains.
Successful selection depends on a keen analysis of the issuer’s fundamentals. Key considerations include earnings trajectory, debt levels, and the strength of management. Avoiding bonds from structurally challenged sectors or companies with deteriorating financials is crucial.
From an investment grade manager’s perspective, extending the holding period for downgraded bonds might ease the forced-selling effect, allowing for more orderly exits and better pricing. For high yield investors, the goal should not be indiscriminate buying, but rather discerning selection.
In sum, while global markets may be clouded by uncertainty, periods of volatility often create windows of opportunity. The dislocation caused by downgrades can be painful for some but profitable for others—particularly those prepared to catch fallen angels. These credits, transitioning from investment grade to high yield, inhabit a unique space in the bond universe—often overlooked, frequently misunderstood, but potentially rewarding for those willing to look beyond the initial drop in status.
In a world where risks loom large and market sentiment shifts quickly, the ability to identify and act on inefficiencies—especially in the credit ratings twilight zone—can deliver meaningful returns. For high yield investors, this is where angels, quite literally, fall into their hands.
