Main Thesis

The purpose of this article is to evaluate the VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL) as an investment option. With the markets sitting at all-time highs, there is merit to taking some risk off the table at the moment. This would include high-yield bonds, which have been performing quite strongly since the March lows. However, ANGL holds fallen angel corporate bonds, which are mostly rated in the higher end of the junk bond market and have strong historical performance backing them up. Further, the continued low rate environment will force investors to hunt for yield, which could draw further investor interest in the fund.

With all this in mind, I see merit to holding on to ANGL, but would caution investors to manage their expectations here. We appear to be in the late stages of a sharp recovery, so initiating new positions does not have the same risk-reward proposition that it did a few months ago. Yield spreads in the junk bond sector have narrowed considerably, so investors need to appreciate that total returns will probably be modest heading into 2021.

Background

First, a little about ANGL. This is a high yield bond fund with a primary objective “to replicate as closely as possible, before fees and expenses, the price and yield performance of the ICE US Fallen Angel High Yield 10% Constrained Index, which is comprised of below investment grade corporate bonds denominated in U.S. dollars, issued in the U.S. domestic market and that were rated investment grade at the time of issuance”. Currently, the fund is trading at $30.45/share and has an annual yield of 5.02%. I continued to recommend ANGL when I reviewed it back in June, as I saw fallen angels as a smart way to play the high yield debt space. In hindsight, this investment has remained profitable, registering a gain over 5% since publication:

Source: Seeking Alpha

While I see merit to owning ANGL as a core holding, the persistent rise in the fund, and total bond market, is making me cautious going forward. Therefore, I believe a neutral rating is now more appropriate, as I see the fund offering low single-digit returns, at best, by year-end, and I will explain why below.

Short And Long-Term Performance Justifies Holding ANGL

To begin, I want to discuss a primary reason why high yield bond investors would want to consider fallen angels, and ANGL by extension. In one word, the reason is performance. Due to the fact that these bonds were very recently rated investment grade, they tend to be in a better financial position than the average high yield bond. This, in turn, leads to stronger underlying performance over time. As a result, funds like ANGL actually tend to do quite well, especially relative to the broader high yield and aggregate bond markets.

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As I noted in the prior paragraph, ANGL has indeed been registering gains over the past quarter. But to illustrate ANGL’s outperformance, let us take a look at how the broader high yield corporate bond market has performed, as measured by SPDR Bloomberg Barclays High Yield Bond ETF (JNK) and an aggregate bond fund, iShares Core U.S. Aggregate Bond ETF (AGG). Over the past three months, roughly from when I last recommended ANGL, the divergence between these three funds is clear:

Source: CNBC

My point is to give a frame of reference to ANGL’s performance. Yes, the market as a whole has been rising, but ANGL’s spread over other options of similar credit quality is notable. Furthermore, this performance spread is not a short-term phenomenon. If we look at the performance of the fallen angel sub-sector of the high yield market, compared to the high yield market as a whole, we see a similar pattern emerge over the last two decades. In fact, since 2003, there has not been a prolonged stretch where fallen angels have underperformed, and their outperformance has been very notable over the last five or six years, as seen in the graph below:

Source: VanEck

Ultimately, my takeaway from this story is that I truly believe, for investors wanting to beef up the yield in their portfolio, fallen angels are a smart way to do it. It is a way to push the risk envelope a bit, without going too far down the risk ladder, and the short and long-term rewards should be apparent. As a result, I definitely see the merit of having a fund like ANGL as a core holding.

Spreads Suggest Further Upside May Be Limited

While I just discussed the merits of owning ANGL, I want to emphasize that I am getting a bit more cautious at current levels. As such, I have a more neutral outlook, not because I do not have faith in the long-term story, but because I see limited short-term upside at the moment. As my readers know, this rebound, in stocks and bonds, has exceeded my expectations, and I am not confident this disconnect between the broader economic picture, and the markets can continue from here. As such, I am raising cash, building quality fixed-income positions, focusing on large-cap stocks, and adding to my equity hedges, such as gold. With this in mind, my expectation for ANGL is to see a small positive gain for the remainder of the year, supporting a neutral rating.

To understand why, let us take a look at high yield spreads, which give a good indication of how much compensation investors are getting for the risks they are taking by investing in this space. While spreads have been narrowing for a while, they have fallen very sharply over the past two months, as seen below:

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Source: Bloomberg

My take on this graph shows that the “easy” money has been made. I’m not suggesting spreads are suddenly going to widen, but there is a limit to how much they can narrow before investors determine these bonds are no longer worth the credit risk. As the graph shows, spreads have been flattening out since hitting the short-term low, which tells me it will be difficult to squeeze more gains out of this sector for the time being. Of course, the income stream from high yield, and ANGL, in particular, remains attractive, but total returns will be limited if spreads are not able to tighten further. Since that is the scenario I am anticipating, this reality supports my neutral view.

Investors Do Need To Take Risk To Earn Positive Yields

Despite my more cautious outlook this time around, there is merit to moving down the credit ladder somewhat. While I am hesitant to recommend this strategy so late in the recovery, that is why I find fallen angels more attractive than the broader high yield sector. Most of the bonds are BB-rated, so they are only one notch down from investment grade. This means investors can access the high yield market, but do not need to expose themselves to the more dangerous C-rated bonds. In fact, ANGL has over 92% of its holdings in the BB-rated category, as shown below:

Source: VanEck

My point here is that, while ANGL is focused on junk bonds, there is much less credit risk (in terms of ratings) than a traditional junk bond ETF. For comparison, let us look at the portfolio composition of JNK, as shown below:

Source: State Street

Therefore, in terms of managing credit risk, ANGL could pique the interest of those worried about taking on too much late in the cycle.

A second reason for considering ANGL has to do with the yields offered in the investment grade corporate sector. As I noted, I have been acquiring bonds of the highest credit quality recently, as the macro-economic conditions continue to concern me. However, now that I have built up positions in investment grade corporates and munis, continuing to add to those positions is getting less desirable. Due to the higher credit quality, those bonds (and funds) have lower yields, and spreads continue to narrow within that space as well. In fact, when we consider real yields, investment grade corporates are now in negative territory, which is a rare occurrence:

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Source: Financial Times

Ultimately, investors are starting to get forced away from the highest quality assets, such as treasuries and investment grade corporates. With savings accounts and high grade bonds yielding negative amounts when we consider inflation, it does make sense to reach for yield to some degree, as long as investors make sure to stay within their own individual risk tolerance.

High Supply Remains A Headwind, But It Is Manageable

My final point concerns an attribute that was present during my last review. This is the rising issuance in the high yield sector, with companies flocking to issue new bonds as interest rates went lower. In fact, new issuance in the high yield corporate bond sector is expected to rise by 17% this year, on a year-over-year comparison, according to a report from Moody’s Analytics.

The point to consider here is that new issuance could pressure the underlying prices of the bonds, especially if investor demand wanes. If state re-openings do not go as planned, further stimulus measures stall, or investors simply decide they want to take some profits, the rising supply may not find its way to willing buyers. This is an important risk to consider as we move into Q4. However, investors should also recognize that a good portion of this new issuance is being used to refinance existing bonds at prevailing, lower rates. Therefore, that 17% bump in new issuance is not going to result in 17% more bonds on the open market. This mitigates the supply risk to investors for now.

Bottom Line

ANGL continues to rise, vindicating earlier buy calls. While I see attributes that could push the fund higher, I believe we will see modest gains to wrap up the year. High yield supply has risen, spreads have narrowed, and corporate profits remain under pressure. That said, I do like ANGL’s relative value compared to the broader junk market, considering its heavy focus on BB-rated bonds. Therefore, I continue to see merit to owning ANGL, but would encourage investors to manage their expectations for the rest of 2020.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ANGL over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



Via SeekingAlpha.com