Fallen Angel Bonds and Rising Stars: Risks and Opportunities

High-yield bonds, also referred to as junk bonds, can be divided into two specific classifications. Bonds that are described as fallen angels are simply those that at one time in the past were considered to be investment grade and are now categorized as “junk” bonds due to a reduction in the issuer’s credit rating. On the other hand, rising stars are bonds that were considered speculation grade when issued, but have since improved their financials, reducing the risk of default. These bonds are now closer to the security of an investment grade bond. So while rising stars are junk bonds, for now, there’s a good chance they will not always remain as junk bonds. (For more, see: Junk Bonds: Everything You Need To Know.)

A typical rising star is a new business or company that simply has a very short or no record of debt repayment from which to assess them high enough for investment-grade. These corporations are performing strongly, thus are “rising” and therefore may become investment grade as soon as the assets required to have the right ratio are achieved. In general, a rising star is a superior performing bond considered a “junk” or speculation grade investment.

While it’s pretty clear why most investors target rising stars, what’s also true is that some specific investors also target fallen angels. By looking for fallen angels and attempting to determine those about to lose their rating, investors may be able to get an increased return on their investment if they time it properly.

According to Henderson (2015), primarily a company becomes a fallen angel due to either specific issues within the company or the industry the company operates in. An industry may have fallen out of fashion, or perhaps acceptable levels of risk on key metrics for the company or industry have been re-evaluated. When issues arise from internal struggles of the company, this is typically the result of using debt instruments to finance things during the wrong part of development. Of course, an inferior credit quality development of a bond will lead in most cases to a decline in the price value and hence to downturn fluctuations in your portfolio. However, fallen angels may still create positive opportunities to generate strong returns. By anticipating a temporary downgrade, investors may access what they know to be an investment grade risk at a temporarily higher return by investing during the security's temporary fallen angel status.

Identifying a rising star bond at the right stage of the market cycle can obviously be highly beneficial. As well-described by Henderson (2015), improvements in rating tend to reflect internal improvements within the business, which means the corporation is more likely to be able to meet their financial obligations. When a company has earned a rating that is considered investment grade, it means that its prospects for securing funding improve as it now has access to all those investors whose portfolios cannot tolerate the added risk they would add if still carrying junk bond status. This can often lead to an increase in demand for a corporation’s bond issue which tends to drive up the price as well.

Through the last several decades, high-yield, or junk-rated securities have experienced tremendous growth. According to McCarthy (2015), this has come about in large part because of the original work of identifying fallen angels in the 70s and rising stars in the 80s (by Michael Milken and others). Today, such high-yield securities make up around 70% of the leveraged finance market in Europe, which is €370 Billion and 60% of the U.S. market which is $2 trillion. With the growing demand for such investment options both on the part of companies and investors coupled with the inability of traditional funding options to keep up, there does not appear to be any signs that this growth will slow down at any time in the foreseeable future. (For more, see: A Brief History of the U.S. High Yield Bond Market.)

Rising stars are clearly not easy to assess at the right stage of the cycle, particularly for private investors. Often, investment professionals are needed to properly evaluate the risk/yield of an individual bond when the rates are higher than investment grade. As is commonly known, in a market that works well, higher than normal yield to risk ratios tend to disappear quickly as market forces will bring about equilibrium before too long. Moreover, investors who are dealing with higher-yielding securities should apply meticulous risk management practices, as well as careful due diligence.