Animal Spirits Podcast - Talk Your Book: Investing in Fallen Angels

Episode Date: January 16, 2023

On today's show, we are joined by Fran Rodilosso, Head of Fixed Income ETF Portfolio Management at VanEck to discuss rising stars vs fallen angels, how to be tactical with fixed income, what a fallen angel is, and much more!   Find complete shownotes on our blogs...  Ben Carlson’s A Wealth of Common Sense  Michael Batnick’s The Irrelevant Investor  Like us on Facebook  And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation.      (Wealthcast Media, an affiliate of Ritholtz Wealth Management, received compensation from the sponsor of this advertisement. Inclusion of such advertisements does not constitute or imply endorsement, sponsorship or recommendation thereof, or any affiliation therewith, by the Content Creator or by Ritholtz Wealth Management or any of its employees. Investments in securities involve the risk of loss. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. The information provided on this website (including any information that may be accessed through this website) is not directed at any investor or category of investors and is provided solely as general information.)  Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits Talk Your Book is brought to you by Vanek. Go to Vanek.com to learn more about their fallen angels ETF that we're going to talk about today. Again, that's vanac.com. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holt's wealth management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritthold's wealth management. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Ritthold's wealth management may maintain positions in the

securities discussed in this podcast. Welcome to Animal Spirits of Michael and Ben. Michael, to show you how little I knew coming into my first job, my first role as a performance analyst, this is before we had systems that could just do this all for you. And on a spreadsheet, I had to calculate for each of our portfolios because they had guidelines. The average credit rating for all the bonds were in the portfolio. So we had separately managed bonds. I'd have all the individual bonds, treasuries, corporates, mortgage bonds. And I would have to calculate.

What year was this? 2004, probably. Boomer. Do it all by hand. Well, not by hand, it was spreadsheet. And calculate it myself. So I'd have to calculate the average weighting and then multiply that by the rating. I'm saying.

Kids don't know how good they have it these days. It's true. So honestly, though, coming into that job, I did not. not know what a credit rating was. This is how little I knew. Obviously. Well, of course not. How would you? I learned what a credit rating was and how it worked and the different rating agencies and Moody's and S&P and all these things. The thing is Moody's and S&P have their own two different scales, though, for the AA, AAA, B, whatever. They have their own thing. BAA1. It's all these different, a little confusing. I thought you were going somewhere with this story. I thought you were

going to close the loop. Well, the loop is of the fact that we're talking about high-yield debt today, so I learned what the cutoff is for high-yield debt. Do I know it now? No, probably not. What is it? It's so the B's double B. I think it's below triple B, is that right? Once you get double B that's high? This was a good one. There are some unique dynamics inside of the fixed income market, as Ben just mentioned, credit ratings, and there are guidelines and mandates that institutional investors often set out where they are restricted. This is how I'll close the loop. helps manage money for pension funds and endowments. And they would have specific guidelines saying we cannot invest in high yield. We can only invest in investment grade bonds. And if they had any high

yield bonds, they'd boot them out of there because they could invest in those. This is a dumb question. Why would you limit yourself to only investment grade? Now, I think I know, but like why? We're talking about higher expected returns. Like, why would you do that to yourself? I think a lot of times it was that's what everyone else does. And if you're in a pension plan, there were certain mandates you had to realize and reach. Here's one. Just style box. just as a way for investors to bucket different investors, different categories. It does seem short-sighted, but that was like the rule, where if you had something that didn't meet your guidelines and we had to follow these guidelines on behalf of these pension plans,

then it was out of there. Get it out of the portfolio. So today we spoke with Fran Rodoloso at Van Act. They manage an ETF, the Fallen Angels, ETF. And what this does is it invests in companies that are below the line of investment grade, companies that got downgraded. That's why I called Fallen Angels. And theoretically, and also, I guess, in practice, you would expect that these just have a higher credit quality and a higher expect to return.

Instead of investing in a broad, high yield universe, this is essentially a factor strategy within high yield, but it has specific rules in terms of like bonds that can take. And basically it's bonds that have gone from investment grade to junk because they've been downgraded. And I think it's a very interesting strategy. The bond market is never all that interesting in my mind, but this strategy interesting, and so with this talk. So here's our talk with Fran from Vanek about the Fallen Angels ETF. We are joined today by Fran Rodelow. So Fran is the head of fixed income ETF portfolio management at Vanek. Fran, welcome to the show. Thanks a lot, Ben and Michael. Thanks for having me. So today we're talking high yield. We're talking about the Fallen Angels fund that Vanek

runs, which is a pretty interesting fund. Michael and I have certainly looked at it in the past. Great ticker. Yeah, what is it, ANGL? You guys got ahead of that one pretty good. Maybe you just give a broad outline of what the fund is and what it does or the index that attracts? So the fund was launched in 2012, by the way, and the ticker and the fund idea, by the way, our product team headed up by Ed Lopez on the ETF side, he came up with the idea of taking index that Bank of America's legacy indexing team, which is now ICE indexes. They had a live index in the space going back to around 2004, and it was back tested back to 1997. The return history, even versus the broad high-yield universe, was remarkably good. And the question from

portfolio management side was, is this universe ETFable? It's a subset of the broad high-yield universe, usually about 10 to 15 percent. It's bonds that were originally issued as investment grade that were downgraded to high yield, as opposed to bonds that were original issue high yield. And that's the basic rule for the index that this fund tracks, although there is an issuer cap at 10%. Ed had to come up with the idea of translating this subset of the high-yield universe into a product. And the return profile has continued to be quite impressive since launch in early 2012. So, Fran, maybe we could start out with where do these ratings come from? And what does investment grade mean? And when does something trigger from one to the next? I think the whole

idea of investment grade and speculative grade to put a euphemism over high yield or junk or whatever else people like to call the Zop Investment Grade universe. It's a fuzzy line in terms of really what that means in terms of credit fundamentals, but the line of demarcation is anything triple B minus rated or equivalent and above by the ratings agencies is investment grade. anything double B plus rated or below is high yield or speculative grade. How the ratings agencies have pretty similar methodologies, they all have some differences. They apply a lot of math as well as fundamental analysis to everything is about the odds of default, the likelihood of default looking forward.

So even the difference between a single A bond and a double A bond in the investment grade universe really comes down to very small differences in a very low likelihood of default. High yield bonds basically are in that category of having no longer moderate default risk, something greater than moderate. A lot of loose definitions around that. The likelihood of default, how is that quantified? I'm sure it's not like one divided by the coupon, but could you explain to us how the math works? I think from an analyst or ratings agency perspective, they're looking at cumulative default rates over a number of years. So they're going to look at a particular company and let's say it issues a 10-year bond and they're going to say, okay, over those 10 years, what's the cumulative likelihood of default before this

thing matures? When you're looking at from an investor's perspective, you're saying, well, this thing is a pretty risky company and maybe it will default, but I'm getting paid 10% a year to own it if there's a 50% chance of default in the next five years, but I might get 40% recovery. it still might be worth owning this if it doesn't default for the next five years. So what spreads in the high-yield universe really reflect are sort of the premium you're getting to account for the fact that some percentage of that universe is going to default over time. And the credit rate agencies, by the way, put out these matrices of if you look at a AAA bond over 10 years, it's way less than 1% cumulative probability of default for those bonds. I think double B,

or a single B bond right in the middle of the high yield universe, over a 10-year period, it's like 20% cumulative probability of default. But over the long run, in a U.S. high-yield market, you're talking 2 to 3% a year, actually defaults on average. And obviously that changes over time, but that's sort of an average default rate. For the Fallen Angel, I'm going to put out the thesis and let me know if I'm correct here. The idea is you have these investment-grade bonds, they get downgraded for whatever reason because their prospects are worse or whatever.

and maybe some pension fund or endowment or whatever fund can't hold them anymore because their guidelines say we can't hold high yield, we can only hold investment grade bonds. These bonds get hammered a little bit and the idea is hopefully them falling on hard times is sort of a short-term thing and they'll eventually get upgraded again or they'll get sold off enough that the yield is more attracted than it should be. Is that the general idea? It's really well put, Ben. It's exactly that there is a bad technical situation around a bond when it's transitioning from the investment grade universe to the high yield universe, much larger investors, many more investment dollars in the IG universe. And there are some constraints around some of those investment portfolios

in terms of how much subinvestment grade exposure they can have. So they do become four sellers. To put some numbers around it, the life of the ICE index that are fund tracks going back to the beginning of 2004, on average, the fallen angel bond in price terms loses about 8% of its value over the six months into that downgrade that puts it into the high yield universe. What's really interesting is over the next six months, it picks up about 90% of that, it recovers about 90% of that price loss and ensuing six months. And 8% is a big loss in bonds, right? It is. And so it so happens that by laws of averages, bonds on average have entered this Fallen Angel index that we track at in the low 90s in terms of cents on the dollar, which does matter. In high yield, it matters

maybe even more because when you think about the lower occurrence of defaults, but they do happen, your default loss is lower when you're starting at a lower average dollar price. But it also gives you a chance for capital appreciation. If you look at any rolling 10-year period, even most five-year periods, the broad high-yield market has a negative price return. So more than 100% of the return for investing in high-yield bonds comes from interest income. And then you have some price loss because of default loss, basically. The Fallen Angel index over any rolling long period of time actually has positive price impact on overall returns. So that's one big difference between Fallen Angels and original issue high yield. Could you talk about

the following. So I would assume that prior to 2022, Fallen Angels competed with junk bonds for dollars for investment eyeballs, which competed with the stock market to a certain extent. But in a world where you can get four plus percent and risk-free treasury bonds, does now the equation change where investors are comparing this to what they can get from Uncle Sam versus what they can get in the stock market? Absolutely. I mean, the traditional rationale for investing in high yield is equity-like returns with lower volatility. Broad high yield has done a little worse than the S&P annually over the last two decades. Fallen Angels have actually done a little bit better. But absolutely, people were moving into high yield the last

couple of years, either because in the public markets, there were very few places to go for any yield, or as you say, they were like, we have enough equity exposure, where else can we possibly get some kind of decent returns. After a year like 2022, as you say, we went from one and a half percent, 10 years to briefly over 4 percent, or as you say, holding cash can get you four and a half percent. That is probably the toughest selling point for high yield right now, but you are talking for Fallen Angels, which are 87 percent double Bs to 67 percent double B plus, so the higher end of the rating spectrum, still yielding about. seven and a half percent. So it's still pretty attractive. Pick up over, say, five to ten year

treasuries. How low did those yields go? Because didn't the spread for regular how you'll get to, I don't know, four percent or something? It was really low at the bottom. It got to under 300 basis points. You might have touched a three handle. And that's at a time where yields on government bonds were low. Correct. So there was total yield compression across the curve, but also spread compression. I mean, this was the last, call it 10 to 14 years, you go all the way back to the global financial crisis. The pricing of risk was obviously skewed a lot by free money. And that impacted credit as much as it did equities or crypto or just about anything else. But recently, Broad High Yield was yielding over 9%. That's back inside of that. That's actually even going back before 2008,

much closer to longer term averages for the asset class. So pretty quickly, but that's, That's with double-digit negative returns last year for these asset classes. But pretty quickly, we've gotten a lot closer to some of the historical reasons for investing in high yield, which is really something closer to equity-like returns. I have a question. We're going to talk about spreads and the cycles and maybe went to buy, or if there's time to be opportunistic. But before we get there, I want to talk about something that Ben mentioned.

Is there like a value-like quality in that the baby gets thrown out with the bathwater, but in a structural way because there are mandates that say that certain funds or strategies or pensions or whomever can only hold investment-grade bonds. But then you say that out loud and you say, well, there's got to be somebody on the side of the trade that would close any potential, I don't want to say arbitrage because that's not what this is, but any sort of force selling you would think would be picked up by, I don't know, somebody. So could you explain how that dynamic works?

I think usually what happens is when you're seeing a large wave of downgrades ahead of time you think, okay, yeah, guys have seen this Fallen Angel phenomenon work out repeatedly over a couple of decades now or several decades. They're going to fill that in. They're going to be better bids than last time around. I think what happens are a couple of things. One is probably the smartest guys in the high yield universe are the distress guys. At the same time, you're seeing a big wave of downgrade. You're seeing a big wave of defaults among the existing high yield universe. That's where that money is focused. And so those guys aren't spending as much. much time on something that was a triple B that's now a double B. In all honesty, I believe that

plays a role in leaving opportunity for other buyers. The other thing is often it's in sectors that are really out of favor. So 2008-9, banks became over 25, closer to 30 percent of the index we track. In 2004 and 5, it was the GM and Ford became over 30 percent of the index. In 2015 and early 2016, it was the energy sector. And then the same thing in 2020. People did not want to get near that sector. People were not very excited about adding risk to those sectors at the time those downgrades were happening. By the way, as a passive portfolio manager, so I want to make that clear, I'm managing to an index and trying to track that index. Having to add those bonds at that time makes my job and my team's job a lot easier because I'm not sure we would always have the

stomach to do it if we were active managers. Oh, that's a good point. Being that this is an index, what sort of rules are you following? Is there a certain number of holdings you need because it's probably a cyclical opportunity set? So how do those rules work for picking which bonds to choose? The ICE index that we track captures the whole universe with a few constraints. I mean, this is the U.S. high yield market, the portion of it that was original issue investment grade, which means it's mostly U.S.-based issuers. It could be other G7 issuers who issue in the U.S. market. If the bonds are more than a year to maturity, still have a rating and have more than $250 million outstanding, they're going to qualify for this ICE index

if their average rating falls below double B plus or below. It's interesting because people ask a lot when we're talking about the strategy with investors, well, don't you catch a lot of falling knives or try to catch them and don't you buy not just the babies that get thrown out with the bathwater, but some of the really dirty stuff. And we're like, yeah, actually, we do. But then again, some of the things you think that might be the worst credits actually enter this index, not at 92 cents on a dollar, but at 62 cents on the dollar. So sometimes it might be a bad company, but at 62 cents, it might not be a bad bond. I think that's such an interesting point. Like, there is a big advantage to being a forced

buyer to buying things that no logical investor, a rational investor, I should say, would say, you know what, I like this company. But that's the point. That is the exact point. So let's talk about the opposite of what happens when a company gets upgraded from, I guess, high yield back to investment grade. Does that come out immediately? Like, what's the process of that? As part of the answer to your question, Michael Bennett asked before about some of the other rules. So this index reconstitutes and rebalances monthly. So something gets downgraded to high yield or upgraded back to investment grade, say on January 15th, it would fall out of our index on the last business day of January. And we would be adding the new fallen angels or the bonds

that are re-rated back to investment grade, the market calls rising stars. How often does it happen? Rising stars average about 5% of our index exits annually via the rising star route. In 2022, it was about 18% of our index. So 2022 is actually the highest percentage of rising stars we'd ever seen. Craft Hines was the largest. It was almost 10% of our index at the time it came out. So that explains a lot of it, a lot of that year of high rising star occurrence. It's a really important part of the strategy. I'd say there are several factors that have led to major differentiation returns versus broad high yields. And one is buying bonds cheaply. But the other one is that Rising Stars, the last 12 months into that upgrade to investment grade,

they outperformed a broad high yield market historically by about 7 percent, 12 months into that upgrade. So the fact that we're buying things the month they're downgraded or the end of that month and we're selling them the end of that month that they're upgraded, it worked out historically to be pretty good timing. And again, Michael, to your point, we're forced to do this in a way. Look, we have some latitude in order to manage liquidity, market impact, and other things. So we'll use a lot of tools in terms of execution, and so it's not to be wholly predictable,

how and when we're going to do things. But generally speaking, at or around those times, we're adding and subtracting in line with the index. It makes it a very disciplined, very contrarian strategy. There are certain allocators who will have a sleeve to high yield, and they will hold that and rebalance regardless of what's happening in the market. Then there are other people who are more opportunistic about the way that they implement fixed income. And maybe they only put high yield in their portfolio when spreads below out to a certain degree or when a recession happens. I'd love to hear your thoughts on how a recession would impact a strategy like this and what investors could expect.

And if that is an opportune time for people to get into this sort of strategy, if they are trying to time this kind of market. What's interesting is there have been only a handful of recessionary periods in this century, 0102, 0809, COVID. 08 was a big down year for high yield and for Fallen Angels, so that we outperformed. The other two periods were actually pretty big positive return years, but the years after that, 02 was actually not a good year, but a couple of years past that, 09, 2010, great years, the second half of 2020 and 21, great years for high yield. So high yields in general, it's usually a good time tactically to come in.

You see spreads blow out, starting to factor in recession and high default. rates. Sometimes it's 700 basis points, sometimes a thousand rarely. Do we get over a thousand basis points spread and high yield? But tactically, those are great times. Fallen Angels have done even better than high yield actually going into and coming out of those recessions. So it is a very good time to think about Fallen Angel strategies. The way we put it with investors who are more tactical that was Fallen Angels or strategic, really, they've outperformed broad high yield through most market environments. They underperformed in 2022, so I'm going to make sure I mention that, but 19 years of live index history, there have been 15 years of outperformance of Fallen Angels versus Broad

High Yield. We launched our fund in 2012 in March. If you count 2012, call it 10 years of live fund history, we outperformed Broad High Yield eight of those 10 years. And we're talking by 200 to 300 basis points on average a year over those periods. So it's really meaningful. and it works through the cycle. But back to your original question, yeah, spreads can blow out during a recession. If you're more tactical, you wait to see those big waves of downgrades and defaults, which are lagging indicators of the credit cycle, by the way, by the time those downgrades and defaults are occurring, usually we've already bottomed down.

Most investors probably need what you have, which is a forced buying mechanism then because that's the time that's hard for most investors to think this makes sense to buy because they think it's going to get worse and the economy is going to go worse. And it's hard to buy at that point. Exactly. And sometimes the worst sectors are the most difficult to buy. And sometimes in our strategy, that's what we're adding, the one that's seeing the most downgrades.

Frank, can we talk about when a company goes to the market, one of the cruise companies, for example, in 2020 when they really are desperately needing some liquidity? How is that risk price? That's through an investment bank. And is they're negotiating between the company, the bankers, and the buyers? How does that all work? I think the bankers feel the market. feel the market out. They obviously are able to analyze via comps and where existing bonds are

trading. They do some preliminary indications out to the market and get feedback and come back to the issuer and say, yeah, we think we could raise a billion dollars for you. And in case of the cruise companies, you're going to have to secure it and it's going to be double-digit yields, which is what happened to some of those guys in 2020. At that point, that was what the market would bear and some of those companies needed it and they did it. They actually bought back those issues and in a lot of cases over the next 12 to 24 months, which is something you'll see a lot in the high yield market, people trying to refinance that higher coupon debt if their situation improves. In terms of setting some expectations for investors, obviously people might look at

these and think, oh, just the yield looks so juicy. That's great. I'm going to clip my coupon and whatever, close my eyes, but high yield in general often has equity-like risk. It might not fall as much as stocks, but certainly double-digit 10, 15, 20, 25 percent losses are not out of the ordinary, especially if spreads really blow out. So how do you think it's intelligent for people who are not used to investing in this space to understand what that drawdown profile can look like? I think there haven't been too many calendar years, even for the broad high-yield market of negative double-digit returns, really only one, which was 2008, but that was a minus

high-20s return for broad high yield in that year. But you have to think of this market is more highly correlated with stocks than it is with treasuries. In fact, during most periods and over long periods, a negative correlation with treasuries and a fairly high correlation with the equity market. So just directionally, you have to get comfortable with the fact that If your equity portfolio is not doing very well, you may be seeing spreads blowing out or at least moving higher and high yield in price terms not doing so well. If you own a high yield portfolio at a time when spreads are attractive, though, that's why it's been that equity like return with lower volatility is the carry really smooths out some of the returns. So there are plenty

of years where there have been negative double digit price returns, but carry, has put those returns or current income back into the mid-single digits negative return. I think you have to understand that high yield or speculative great debt, same with levered loans. They're going to be more sensitive to what's going on in the general economy. It's not a hedge against your equity exposure the way pure treasury exposure is, in fact, quite the opposite. In terms of performance, how out of the ordinary was it, Michael and I think talked about this on our podcast once, that junk bonds actually outperformed treasuries last year or in the bond downturn. How out of the ordinary is that in a down market for bonds that treasuries underperform?

It's actually pretty common. It was more unique last year that a lot of years when treasuries have gone down, it's a time when the market's coming out of recession, entering a new growth period. And often that means spreads, which were wider than average, start narrowing. And you already have a lot of high yields in the high yield universe. So a lot of years actually where treasuries have had negative returns, you've seen high yield of positive returns. What was more unique about last year, I wouldn't say not predictable, given how compressed

everything was, once the valve was released, once the Fed either took or fed the market, the harsh medicine, almost everything that was tied into that liquidity trade was going to correlate. It was a unique year. That was the first year. I think you can take histories of the ag. Think of the global ag and the S&P 500 go back 45 years, 1977. That was as far back as we could go. Last year was the first year that the ag and the S&P were both down in the same year. And double digits in the same year. It was remarkable. So usually, actually, that's why in a diversified income portfolio, having high yield exposure has worked really well because it can negatively correlate with treasuries. You can have very good returns, even in years where

treasury yields are moving higher. In terms of how this is more stock like than bond-like, was one of the reasons why this category outperformed both bonds and stocks is because, A, the credit quality held up. There was not a lot of bankruptcies or defaults. But more importantly, the duration on these things, it's much less sensitive to increases in interest rates. Can you talk about it? about that factor? Correct. I mean, broad high yield came into last year with a duration, I think, a little less than four. I forget where the ag is, but high six is, I believe. And if you look at some of the longer data treasury ETS, those are double digit durations. So one, yeah, the interest rate duration itself is low, but also often it's spread movements and carry your current income

that are more dominant in terms of contribution to returns over a given year for high yield. So even that the sensitivity to interest rate moves is lower because there's that yield buffer, just in general, and there's lower duration. I should mention at this point that Fallen Angels tend of a higher duration than broad high yield. That's because high yield market rarely do you see a new issue, original issue, high yield more than 10 years of maturity, a lot of stuff around 5 years. Who would let them money for 10 years? Not me? Yeah, a lot of people wouldn't, nor do companies necessarily want to lock in that high cost of debt capital for 10 years, although also most high yield issues are callable, which most investment grade bonds are not perfect point. So since Fallen Angels are original issue investment grade, we do have a lot of bonds in that index that were issued beyond 10 years to maturity and some that still are. So it started last year at the duration in the high sixes. Finish the year at a duration in the mid-fives, though. So now it's about. 1.2 years longer than a broad high yield market. And that being said, even with longer duration,

there have been 10 years over the life of the ICE Fallen Angel Index, where either Fed funds or five-year yields have moved significantly higher and fallen angels have outperformed broad high yield seven of those 10 years. Interest rate duration tends to be outweighed by other factors when you're talking about high yield in most years, not in 2022, however. Fran, anything we missed that you wanted our audience to learn about this fund or this style of investing? I think we've covered a lot. Credit us.

We did pretty well. Okay, where can we send people to learn more about the fund? Well, certainly the Vanek website is always a really good place to start, and there'll be lots of links to information, Q&As, or FAQs, if you will, about Fallen Angel investing, about our fund. There'll be some blogs, and we'll be trying to be pretty frequent in terms of our output and comments on the market. update. So a lot of information to be had on the Vanek website. We will link to all of that and more

in the show notes. Fran, this was fantastic. Thank you so much for your time. We appreciate you coming on. Thank you very much, Michael. I'm Ben. I really appreciate it. Thanks to Fran. Thanks to Vanek. Check out the show notes for any links to the research, the fund. Remember email us, Animal Spearspot at gmail.com. We'll see you next time. Thank you.