iShares Fallen Angels USD Bond ETF (FALN)
Closing Price- $27.11 (as of 09/09/2024)
Dividend Yield- 5.91% (monthly basis, paid $1.60 per share in the past year)
1y Total Returns- 10.55%
Sharpe ratio- 2.55 (1yr past trading)
Expense ratio- 0.25% (5 year)
Effective duration- 4.78 years
30-day SEC yield- 7.13% (standardised yield, based on most recent 30-day period of dividend and interest earnings)
1.) High Yield Corporate Bonds and a Brief Outlook
Corporate Bond Outlook
Corporate bond investments generally outperformed treasuries in the first half of the year, supported by higher income payments and falling spreads. Riskier investments like high-yield corporate bonds, bank loans, and preferred securities outperformed investment-grade corporates.
High Yield Bonds (Junk Bonds)
A high-yield bond, or junk bond, is a corporate bond that represents debt issued by a firm with the promise to pay interest and return the principal at maturity. Junk bonds are issued by companies with poorer credit quality. A bond is considered non-investment grade if it has a rating below BB+ from Standard & Poor's and Fitch, or Ba1 or below from Moody's. Bonds with ratings above these levels are considered investment grade. Credit ratings can be as low as D (in default), and most bonds with C ratings or lower carry a high risk of default.
- Fallen Angels — A bond that has been downgraded by a major rating agency and is headed toward junk-bond status because of the issuing company’s poor credit quality.
- Rising Stars — A bond with a rating that has increased because of the issuing company’s improving credit quality. A rising star may still be a junk bond, but it’s headed toward being investment quality.
Advantages:
- Corporate bonds remain a solid investment, a resilient US economy has been a key driver of the strong corporate bond performance to start the year. Despite concerns about rising borrowing costs given the aggressive pace of Federal Reserve rate hikes, corporate fundamentals remain solid.
- Corporate profits remain elevated according to the Bureau of Economic Analysis, although the first quarter of the year saw a modest decline from the all-time high reached in the fourth quarter of last year.
- They offer a higher payout compared to traditional investment-grade bonds: The companies issuing these bonds do not have an investment-grade rating, they must offer a higher ROI. This means that if a junk bond pays out, it will always pay out more than a similar-sized investment-grade bond.
- If the company that issues the bond improves their credit standing, the bond may appreciate as well: When it is clear a company is doing the right things to improve their credit standing, investing in high-yield bonds before they reach investment grade can be an excellent way to increase the return while still enjoying the security of an investment-grade bond.
- Bondholders get paid out before stockholders when a company fails: Bondholders will get paid out first before stockholders during the liquidation of assets. If a company defaults the bonds and stocks it issued are worthless, since bondholders get paid out first, they have a greater chance of getting some money back on their investment over stockholders in the event of a default. Once again, the name “junk” can be very misleading as such bonds can clearly provide a safer investment than stocks.
- Recession-resistant companies may be very underrated. The big deal with high-yield corporate bonds is that when a recession hits, the companies issuing these are the first to go. However, some companies that don’t have an investment-grade rating on their bonds are recession-resistant because they boom at such times. That makes the companies issuing these types of bonds safer, and perhaps even more attractive during economic downtimes. A great example of these types of companies is discount retailers and gold miners. Note that the subprime mortgage crisis proved how much rating agencies could get it wrong or change their standing quickly based on new data.
Disadvantages:
- The potential risk of default that comes with the lower credit rating, means that investors may not be paid the interest that was promised and capital will be at risk if companies default.
- Higher volatility and potentially.
- Interest rate risk, all bonds face a risk that if the market's interest rates rise, it will cause the price of the bond to decrease. (However, in the current climate, we have seen a hike in interest rates by the FED in the last year, but we are likely to see a drop in rates in September. Reuters expect FED to cut rates by 25 basis points as of 11/09/24).
2. Fundamentals of the ETF
- The fund tracks the Bloomberg US High Yield Fallen Angel 3% Capped Index composed of U.S. dollar-denominated, high yield corporate bonds that were previously rated investment grade. The fund will invest at least 80% of its assets in the component securities of the underlying index, and the fund will invest at least 90% of its assets in fixed income securities of the types included in the underlying index.
- Listed on the Nasdaq exchange.
- Fund inception was June 14th 2016 and falls under the fixed income/ bonds asset class
- Fixed rate coupon with a maturity greater than 1 year. Distributions are paid by the fund on a monthly basis (similar to dividends received from individual shares, investors will receive 'distributions' when invested in ETFs).
- With an expense ratio of 0.25% and net assets exceeding $1.6 billion, FALN offers investors a cost-effective and liquid avenue to gain exposure to this niche segment of the bond market.
What's the objective?
- For bonds that were downgraded in terms of credit quality, the idea is that these bonds still retain stronger fundamentals and higher recovery prospects compared to their junk bond counterparts that were born into speculative-grade territory. Many investors sell so-called "fallen angels" simply because those bonds were downgraded by credit rating (they are subject to a higher risk of default), not necessarily because of flaws in their financial fundamentals. That means FALN can buy them at relatively bargain prices. Later, if they are upgraded back to investment-grade, they’ll likely rebound in price.
- Fallen Angel bonds are a small and often overlooked portion of the corporate bond markets. However, some unique return drivers may help fallen angel bonds outperform other types of corporate bonds.
- Price rebounding following a downgrade- over the short term, Fallen Angel bonds are often oversold as investors rush to sell ahead of the downgrade, sometimes resulting in a rebound of the bond's price.
- Potential to be upgraded back to investment-quality rated bonds.
3. Holdings
Asset Allocation
Bond Breakdown
Exposure
Exposure Analysis
FALN's portfolio is well-diversified, holding 184 individual bonds. No position makes up more than 3.11% of the fund, resulting in a good mix of positions that would only be at severe risk in a sustained economic contraction.
From a sector perspective, the bulk of the fund is in Consumer Cyclicals. This is common among high-yield bond funds. The overweight in Cyclicals is important because in the event of an economic downturn, these bonds likely would get significantly punished as funding concerns would mount amidst a slowdown in overall macro activity.
From a credit and risk perspective, note that the fund holds 78.08% of holdings are BB rated. This indicates a better credit quality than the peer average of B+. This asset can be seen as a potentially lower risk compared to other HY bonds. However, the potential drawback is that its yield to maturity is lower at 7.02% in comparison to a category average (similar bond ETFs) of 7.6%.
4. Performance and comparison
Over the long term Fallen Angels have outperformed the broad Investment Grade and HY market.
- Fallen Angels represented by Bloomberg US HY Fallen Angel 3% Capped Bond Index.
- IG (corporate) represented by Bloomberg US Corporate Bond Index.
- HY represented by Bloomberg US Corporate High Yield Index.
Growth of $10,000
If we compare the growth of iShares Fallen Angels USD Bond ETF to the performance of the S&P 500 index, we can see that FALN has trailed. However, we have seen that 2023 leading into 2024 has been a strong year for the S&P 500 overall. By the end of November, the index was up about 21%, recovering significantly from a tough 2022. However, the gains have been unevenly distributed, with much of the success driven by a few major tech companies—referred to as the “Magnificent 7” (including Apple, Amazon, and Nvidia). These stocks alone saw impressive returns of over 70%, significantly boosting the index, while the broader market’s performance was more modest.
We can see however, that FALN has been much less volatile in comparison (as expected) with an average percentage change in the investment's value, either up or down in the past month being 1.06%. I believe that corporate bonds remain a strong alternative to equities or a strong addition to a portfolio.
(Note that comparison between two asset classes is sometimes misleading as they are fundamentally very different.)
Three notable peers worth comparing are the iShares Broad USD High Yield Corporate Bond ETF (USHY), iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL).
FALN vs USHY
USHY is a passively managed fund by iShares that tracks the performance of the ICE BofA US High Yield Constrained. It was launched on Oct 25, 2017. USHY, with a broader mandate to track the entire high-yield corporate bond market, may offer a more diversified exposure but lacks the targeted focus on fallen angels that FALN provides
The correlation between FALN and USHY is 0.84, which is considered to be high. That indicates a strong positive relationship between their price movements. We can see the 1Y return of 13.89% for FALN is higher than USHY which has had a 1Y return of 13.19%. However we can see that both ETFs have experienced similar volatility levels in the past and have very close returns.
In my opinion, USHY is a broader investment and is a good alternative ETF to hold but potentially lacks the potential future growth that FALN could have.
FALN vs HYG
HYG is a passively managed fund by iShares that tracks the performance of the iBoxx $ Liquid High Yield Index. It was launched on Apr 11, 2007
We can see that FALN comes up on top when looking at the 1-year return and also the YTD return (by a fine margin). FALN also has a lower expense rate.
If we analyse the expected return compared to risk, we can also see that FALN is a better option as it has a higher Sharpe ratio of 2.55 in comparison to 2.48.
We can see long term (10 year) that FALN has historically proven to have much higher returns. Although past results don't necessarily indicate the same future results, we can see there's a strong positive correlation between the two ETFs (0.83) and FALN has performed much better than HYG. This is attributable to the price appreciation of the fund's 'riskier' bonds over the long term.
FALN vs ANGL
VanEck Vectors Fallen Angel High Yield Bond ETF tracks the performance of the BofA Merrill Lynch US Fallen Angel High Yield Index. It was launched on Apr 10, 2012. It is very similar to FALN as it follows the same objective. We can see however that in every period, FALN has outperformed ANGL every time.
5. Summary
The current outlook for U.S. high-yield bond ETFs is relatively positive, despite economic uncertainties. With the U.S. economy expected to slow and potential Federal Reserve rate cuts anticipated, high-yield bonds are becoming attractive for investors looking to secure higher returns. Yields on high-yield bonds are currently elevated, averaging around 7.7%, which provides a good income opportunity compared to equities. While the strategy for HY bonds carries inherent risks associated with them, iShares Fallen Angels USD Bond ETF has a 1yr total return of 10.55%, a well-diversified portfolio, a robust performance track record, and a cost-effective structure making it an attractive option for investors seeking income and potential capital appreciation.
FALN main benefits:
Attractive Yields and Potential Price Appreciation
With U.S. interest rates peaking after an extended period of Federal Reserve rate hikes, the market outlook for high-yield bonds, including fallen angels, is increasingly positive. Yields on fallen angels are typically higher than average corporate bonds due to their downgrade status. This allows investors to lock in higher yields. Moreover, as economic conditions stabilise and the Fed potentially eases its monetary policy, fallen angels offer significant price appreciation potential. Historically, these bonds have demonstrated strong rebound tendencies, as many of their issuers regain stability and see credit upgrades over time.
Favourable Credit Market Environment
The economic outlook also supports the case for the FALN ETF. Despite concerns over inflation, corporate fundamentals remain relatively robust. Default rates for high-yield bonds, including fallen angels, are in line with historical averages of around 3-4%, which is manageable considering the high yields. As the economy slows but avoids a deep recession, companies may not face the severe financial stress that triggers massive defaults. This is particularly true for FALN, many of which were investment-grade for a reason—solid underlying businesses that temporarily faced challenges. When these companies recover, their bonds often perform exceptionally well. Thus, investing in FALN provides exposure to bonds that are likely to experience a credit rating rebound, especially as market conditions improve.
Diversification and Risk Mitigation
One of the key advantages of the iShares Fallen Angels Bond ETF is that it offers broad diversification across sectors and issuers, which mitigates some of the risk typically associated with high-yield bonds. By holding a basket of bonds from different industries with the top three industries being Consumer Cyclical, Communications and Energy, FALN reduces the impact of individual bond defaults or sector-specific downturns. Investors looking for income generation and capital preservation may find that FALN aligns well with their objectives, especially as interest rate risks are expected to decrease.
In conclusion, the iShares Fallen Angels Bond ETF stands out as a good investment due to its high yield, potential for price appreciation, and diversified exposure to recovering corporate bonds. If an investor is looking for exposure to corporate bonds from companies that have decent credit ratings and is looking for potentially higher ROI than other IG or HY bond ETFs then FALN is a good option. However, although the fund's bonds have the potential to recover its IG status it is important to note that these bonds carry a higher risk of default and the exposure to some distressed companies may make it unsuitable for a risk-averse investor.
FALN Fund Brief https://www.ishares.com/us/literature/product-brief/fallen-angels-rising.pdf
FALN Annual financial statements https://www.ishares.com/us/library/stream-document?stream=reg&product=ISHFALN&shareClass=NA&documentId=1263512~1263510~920966~2253109~2251612~1871405~1896135&iframeUrlOverride=%2Fus%2Fliterature%2Fannual-financial-statements%2Fafs-ishares-high-yield-bonds-etfs-10-31-en.pdf
Disclaimer: The views and opinions expressed in this article are solely those of the author and do not constitute financial advice. Readers should not interpret any information provided here as specific guidance for financial decisions. Always consult with a qualified financial advisor before making any investment or financial choices.