Why these "Fallen Angels" hit the risk-return sweet spot

We could be on the cusp of a new dawn in fixed income.  And oh how dark the night has been.  

The bond market has borne the brunt of the war on inflation waged by central bankers. The Bloomberg Global-Aggregate Total Return Index fell over 22% between January 2022 and October 2022. The index hasn't suffered that kind of rout since it was born in the early 90s.  

The year to date loss has since been pared back to -9.88% as yields have fallen. The US 10 year note was yielding 4.23% in October. It is now sitting at 3.45%. 

All this is good news for fixed income investors, given the inverse relationship bond values and yields share. 

And while most fixed income assets lever off rates set by central banks, there's still a sea of securities that investors can choose from, each with their own risk-return proposition. 

I recently had the opportunity to hear from Alex Veroude, CIO of fixed income at Insight Investment. 

Veroude believes an asset class he terms "US Fallen Angels" offers the best risk-return to investors. So in this wire, I provide a state of play for fixed income before delving into Veroude's thesis around fallen angels. 

How are fixed income investors pricing the economy?

The equity market are as optimistic as ever, believing the Fed will be able to thread the needle on rates. 

"Equity markets are pricing in a soft landing. In other words, if there is a hard landing, then we're probably looking at a further -20% in equity markets."

The bond market, by contrast, is a strange beast - different classes are pricing in different scenarios.

"Investment grade is definitely pricing in a hard landing and a recession because investment grade bond spreads should not be at 200 [basis points]. In a non-recessionary environment those spreads are typically well below 100, [but] we haven't been below 100 in a year and a half."

High yield traders, on the other hand, are sitting on the fence. 

"Generally if it's good economic weather high yield spreads should be around the 250-300 basis point range, and at the market they're around 500. But if we have a recession, high yield spreads should be around the 800 basis point mark."

"Fixed income is schizophrenic at the moment but that's also the opportunity set," says Veroude. 

When do yields become attractive?

Market sentiment in the bond market has shifted from selling to holding, with the buying phase not too far off. 

When does fixed income start making sense from a risk-return perspective?

If you're talking investment grade, Veroude believes the buying opportunity makes sense once yields hit 6-7%. And they're almost there, as the chart below shows:

"These are real returns that compete very competitively with equities."

Moving up the risk curve to US high yield, Veroude believes that buying opportunity manifests between 11-13%.

US Fallen Angels

So what's the sweet spot for risk-adjusted return?

Insight defines a fallen angel as a US bond that has just been downgraded from investment grade to high yield. 

That means anything below Baa (as rated by Moody's) or BBB (as rated by S&P and Fitch). 

In keeping with the flavour of the moment, it's the players who have just been dropped from the starting 11 to the bench. 

This presents what's called a 'forced alpha' opportunity. Many institutions have mandates that don't allow fixed income assets below investment grade. So when these bonds are downgraded, institutions are forced to sell.  

So in a way, you're getting a risk profile that's knocking on the door of investment grade with the performance of high yield. 

That's the fixed income sweet spot, as judged by Insight Investment. 

And with that, I leave you with the below graph, which shows the return differential of these US Fallen Angels against the broader high yield cohort. 

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