Main Thesis

The purpose of this article is to evaluate the iShares Fallen Angels USD Bond ETF (FALN) as an investment option. With the markets sitting at all-time highs, I see merit to taking some risk off the table, by shedding some equity exposure and lower rated high yield bonds. While FALN is made up of junk debt, it holds fallen angels, which are bonds that were recently investment grade and subsequently downgraded. Most of these bonds fall in the BB-rated category, which is a sub-sector of high yield that is typically safer and posts higher returns. Given that leverage is up across the high yield space, I see focusing on fallen angels as a prudent course of action. Finally, FALN has a lower expense ratio and better short term performance than similar funds, making it a good option for investors interested in this space.

Background

First, a little about FALN. This is a high yield bond ETF with a primary objective “to track the investment results of an index composed of U.S. dollar- denominated, high yield corporate bonds that were previously rated investment grade.” Currently, the fund sits at $28.17/share and has an annual yield of 5.25%. This is my first review of FALN, although I have covered the fallen angels sector multiple times in the past by writing on the VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL), most recently in early September. While ANGL has performed reasonably well in 2020, I decided to take a look at FALN, as it is a direct peer. After review, I believe FALN may actually offer a better value going forward, and I will explain why in detail below.

Retail Investors Confident, Options Market Shows Trouble Ahead

To begin, I want to touch on a couple of reasons why investors may want to be considering fixed-income more broadly at the moment. While 2020 has been a volatile year, fixed-income has held up fairly well, but equities have been the primary winners post-election day. With the major indices hitting new highs, investors may be wondering why they wouldn’t be better served riding the equity wave, as opposed to putting capital to work in fixed-income products.

While this is a fair challenge, I would counter that logic by saying the fact that indices are sitting at such high levels is support for building on to equity hedges through fixed-income. The market has been reacting positively to the election results and a potentially effective vaccine being finalized in the short term, but those macro-events do not change the fact that the American economy is in a difficult spot right now. High market valuations are disconnected from the economic reality of high unemployment, low inflation, and persistent partial state lockdowns. While the market is indeed forward looking, I personally think the current challenges are being discounted a bit too aggressively. To further support this belief, consider that the majority of retail investors expect the market to head higher from here, according to the weekly survey compiled by the American Association of Individual Investors (AAII), as shown below:

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Source: AAII

My point here is that even though the major indices are sitting at record high levels, investors still think there are more gains to be had. That makes me inherently cautious, and signals to me that investors should start planning for some sort of pullback. This would involve buying assets like treasuries, gold or other commodities, and corporate bonds through funds like FALN.

Of course, rising stock prices and euphoric investors are not automatically signals to start lessening equity exposure. Momentum can often carry on for a while, and if we continue to see positive progress on the virus vaccine, more gains could certainly be possible. However, there is a third reason besides high valuations and optimistic investors, that leads me to a contrarian viewpoint right now. This has to do with expected volatility, with the options market signaling volatility is going to move consistently higher through the end of the year. To illustrate, consider the graph below, showing where the options market expects the VIX to move throughout the next 12 months:

Source: Yahoo Finance

My takeaway here is that investors would be wise to take some risk off the table from their equities positions. The recent gains have been extremely impressive, so taking some profit and moving in to less volatile positions could prove fruitful. With retail investors largely expecting more gains, but institutional options markets expecting more volatility, I see a lot of merit to taking a contrarian position right now.

Why Fallen Angels? High Yield Looks Vulnerable

Now that I have discussed why I feel increasing allocations to fixed-income positions could make sense at the moment, I want to focus on why investors may consider fallen angels specially. Primarily, this viewpoint comes from the perspective of relative value and safety, compared to the high yield sector as a whole. For those who are very risk averse, focusing on investment grade credit probably is the right move. But for those looking for a higher yield with a little more risk, I believe fallen angels are a smart option. The reason being is that these are some of the safest bonds within the high yield sector. Although they are recently downgraded, which is undoubtedly a bearish signal, most of them are still rated BB, the highest credit rating in the high yield sector. Therefore, when considering high yield as a whole, fallen angels have higher credit ratings, on average, and often post stronger returns over time.

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Of course, investors may consider moving down the rating ladder for the potential of higher returns. While there is merit to this strategy, I do not feel it is timely given current conditions. Yes, the economy is on the rebound and positive vaccine news is great for corporate America. However, corporate balance sheets have been hit hard, and it will take a while to recover to pre-pandemic levels. With corporate revenues and profits down significantly (as a whole, not for every company), many bonds in the high yield category are backed by companies that are extremely leveraged. In fact, the leverage ratio for the high yield sector is at a historically high level, while the coverage ratio is concurrently at a historically low, as illustrated below:

Source: Guggenheim

The point here is that the high yield bond market looks vulnerable, yet prices for these bonds are still fairly high and spreads have narrowed considerably from Q1. With balance sheet fundamentals signaling that many high yield issuers are facing financial difficulty, I would advocate getting more selective on which companies investors are exposed to. Through FALN, investors are buying debt backed mostly by the strongest high yield issuers, which makes sense to me.

FALN Seems To Edge Out ANGL

My final points considers FALN’s make-up compared to its primary competitor, ANGL. Both funds are fairly similar, in terms of objective, holdings, and performance. While I have liked ANGL in the past, and continue to like it today, I have begun to favor FALN over it for a few reasons.

One, the simplest and most obvious, is the cost to own FALN is more competitive. With an expense ratio of .25%, compared to ANGL’s expense ratio of .35%, FALN clearly wins the contest for that important attribute. While both are reasonable, a lower expense ratio is clearly preferable, all other things being equal, and can certainly add up for long term investors.

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Two, FALN has also been edging ANGL out in terms of performance. If we look back over the past year, FALN leads ANGL by about 1%, which simultaneously offering a similar yield, as shown below:

Source: CNBC

Of course, this does not guarantee similar results going forward, but it is something to consider. FALN clearly has a slight edge here.

Three, both funds have similar exposure, so this emphasizes why investors may favor FALN based on the first two points. If we look at ANGL’s and FALN’s sector weightings, respectively, we see a lot of similarity:

Source: VanEck; iShares

As you can see, both funds are heavily weighted towards the Energy and Consumer Cyclical sectors, and there next largest weightings are fairly similar also. In fairness, the funds are not identical, but unless an investor specifically wants slightly more exposure in an area like Financials or Consumer Non-Cyclical, I see merit to favoring FALN here. Therefore, while I still feel ANGL is a fine fund, and the reasons for buying FALN similarly apply to ANGL, I am leaning towards picking FALN as the best option for now.

Bottom-line

Investors are faced with a difficult economy, high stock prices, but encouraging macro-news. As a result, it is not obvious what the investment strategy should be, but I feel locking in some gains and building to equity hedges is the right move. FALN provides a way to do this, but it still gives investors plenty of upside if optimism continues. This fund is not for those who are completely risk averse, as it does hold below investment grade debt, but its bonds are mostly BB-rated and have better leverage and coverage ratios than the average corporate junk bond. With a lower expense ratio and slightly better performance than ANGL, I see FALN as a nice option for those looking to buy the fallen angel sub-sector. Therefore, I believe a bullish rating is justified, and I recommend investors give this option some consideration at this time.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in FALN 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