Fallen Angels - do downgraded bonds offer an opportunity for investment?

The Centre for Asset Management Research at Cass Business School, City, University of London in cooperation with Invesco Powershares has launched the latest in a series of white papers, "Fallen Angels: The investment opportunity", which looks at the investment potential offered by downgraded bonds.

The corporate bond markets can be broadly categorised into two groups: Investment Grade and High Yield.

Investment Grade bonds are those deemed to have been issused by governments or corporations that are highly unlikely to default. High Yield bonds are generally considered to come with a higher risk of issuer default, relative to bonds issued by entities with investment grade ratings, although generally there is the potential reward of a higher yield.

Some bonds however begin life as investment grade but due to a decline in the perceived credit quality of the issuer, they may be downgraded to high yield status. These bonds are referred to as fallen angels. This white paper looks at the impact on bond prices of such a downgrade and why this phenomenon could be of interest to investors.

The possible influence of the Overreaction Hypothesis is considered, in that investors may react too strongly to news of a downgrade, resulting in a sharp drop in price. This drop may subsequently be reversed if an overreaction has been in evidence, wherein an opportunity for investment may lie. The paper also considers institutional influences that may also compel investors to sell bonds in the event of a rating downgrade.

The paper presents a study conducted by the authors in which the price performance of 534 bonds was analysed. The periods for analysis were the 30 days before their downgrade and the first 30 days after. It finds that there is a case for investing in fallen angels, with index investing being the most accessible way into such an investment strategy. The paper concludes that price rises seen in fallen angels, six to seven days after a downgrade, offer an opportunity to enhance the returns on a multi-asset class portfolio, and the potential to improve portfolio diversification.

The paper "Fallen Angels: The investment opportunity" is available for download at the Article attachment link below. The Smart Beta white paper series is also still available for download.

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