Fallen Angels. If bonds are downgraded in terms of creditworthiness and thus lose their investment grade rating, which is important for large investors, there are usually massive price fluctuations. Andreas Fitzner takes advantage of this in the Fallen Angels Fund of Eyb & Wallwitz.
When German automotive supplier ZF Friedrichshafen lost its investment grade rating on March 26, the price of its bond fell like a stone from 97 to 80 percent. Only a few weeks later, the price was back at 98.
"Result of a market inefficiency," is how Andreas Fitzner, together with Ernst Konrad co-manager of the Fallen-Angels-Fonds of Eyb & Wallwitz, describes this movement. In other words, a price development that would not occur if all investors were to behave rationally. "Of course, the rollercoaster ride in the case of ZF was intensified by the excitement surrounding the Corona crisis. What I find interesting, however, is that such fluctuations occur again and again when the credit rating of a bond is revised downwards by the rating agencies and the bond thus loses its investment grade rating. Over the year, this effect alone adds two percentage points to the return on a bond portfolio. That's quite a lot in a zero interest rate era.
If you want to understand the background, you have to delve a little deeper into the structure of the bond markets. The most important investors there are institutional investors - insurance companies or pension funds. These are very much based on the judgements of the credit assessors - the ratings. "Depending on the rating, they have to deposit varying amounts of equity capital when investing. That's why they invest primarily in securities with good or very good credit ratings," explains Fitzner. This investment grade is created by bonds that have at least a BBB- (from the agency S & P) or a Baa3 (from Moody's) rating.
The lowest level of investment grade - BBB- or Baa3 - is where Fitzner comes in. "Today, almost ten percent of all corporate bonds are located there. If they lose just a single rating level, they go from being ennobled investment grade to a high-yield bond in the high-yield sector that is viewed with scepticism. We're talking about fallen angels.
That's when automatisms are set in motion. Because the bonds are no longer part of indices that track investment grade bonds, ETFs that track these indices are selling Insurance companies that track indices sell. Sell special funds. "The price reaction is then often stronger than would have been appropriate in view of the economic deterioration that led to the rating change," explains Fitzner.
Then the wheel keeps on turning. A little later, the Fallen Angels are included in the high-yield indices. New demand is created. Since the entire high-yield market (bonds with BB, B or CCC ratings) is small compared to the investment-grade market, it takes a while for prices to return to the fundamentals.
"This period after the downgrade is therefore a perfect entry point for us. As a rule, prices will have recovered within one to two months at the latest.
That's market inefficiency. In other words, a gift for those who know their way around. "Because, of course, as an investor I have to be careful. Buying all the fallen angels systematically would be risky. Because sometimes the prospects for the company have deteriorated so much that the next downgrade is only a matter of time. Then prices will continue to fall." For the manager, life on the edge is challenging - but also very lucrative.
In the coming months, Fitzner believes he should get a few opportunities to invest. "In the long run, two percent of all investment-grade bonds become fallen angels every year. This year it could be five percent. And then another three percent in 2021," the professional suspects, and explains: "The current recession is likely to have an even greater impact on the corporate bond sector in the coming months. Debt is rising and balance sheet ratios are deteriorating. Then the rating agencies will have to act."
In his fund, Andreas Fitzner does not live on market inefficiency alone, however. "In this area between investment grade and high-yield, the relationship between opportunities and risks is also particularly good for investors." Bonds rated BB, for example, have a much lower probability of default than lower rated B or CCC. "In the BB segment, 0.8 percent of bonds become non-performing each year. So for every 100 euros invested, I lose one. For B-rated bonds it's already 1.3 percent, for CCC it's close to 16 percent.
According to the professional, investors in these lower rating segments are insufficiently compensated with higher yields for the risks assumed. "BB yields a good three percent more than government bonds. This is interesting in view of the manageable risk."
To invest almost exclusively in this area, the manager needs maximum freedom. "We deliberately do not want to invest in all segments of the high-yield sector and must therefore be allowed to deviate massively from the indices that are available as a benchmark. For example, we only have 90 to 100 bonds in our portfolio. The high-yield benchmark has 1200 bonds. We look for opportunities, select individual issuers, and from this we then derive the fund structure."
Phaidros Funds Fallen Angels has been successfully implementing this idea since 2013. In the coming months, the fund could receive additional tailwind from the ECB. To prevent companies in the Corona economic crisis from running into liquidity problems, it is now also buying corporate bonds. However, it has so far only invested in securities with a credit rating in the investment grade range. "In the USA, on the other hand, the FED has long since started buying Fallen Angel securities," explains Fitzner and concludes: "Since it is becoming even more difficult for Europe's economy in the face of rising infection figures in the winter, the ECB could also extend its mandate and buy bonds with a BB rating. This would give the angels additional wind under their wings" ®
// How to invest - in Fallen Angels.
The investment manager Eyb & Wallwitz repositioned its Phaidros Funds Fallen Angels (ISIN: LU0948477962) 2013 in order to consistently benefit from the opportunities offered by bonds on the borderline between investment and non-investment grade. Fitzner invests only in Europe. "In the USA the market for corporate bonds is much larger, but the inefficiency premiums are also lower there. We can still find enough interesting paper in Europe.
Since 2013, the fund has achieved an annual return of 3.3%, which is similar to its benchmark, a global high yield bond index. This is remarkable because the manager only focuses on the strongest segment - BB - of the entire high yield sector.
Although the fund also lost value in the Corona crisis, it has since recovered almost all of it and is now only just under four percent below the level at the beginning of the year.
Eyb & Wallwitz; www.eybwallwitz.de