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The ‘fallen angels’ of fixed income as a factor
When we speak of factors in the institutional investment world, we tend to think about equities investing. But fixed income and credit investing also have their factors. There are just not as many of them. Importantly, though, they can still be a “free lunch” for investors, according to Mellon’s Paul Benson.
Benson is the head of fixed income ‘efficient beta’ at Mellon, an affiliate manager of BNY Mellon Investment Management, which has participated in quantitative analyses of equities since the 1990s and then with credit, including private credit, since the 2000s. But it was not until the last few years that Mellon started to get a really strong uptake in investor interest in its quant-driven credit strategies. This was partly due to historically low yields for sovereign bonds and the related increased demand for credit, including private credit.
Mellon and a handful of other managers observed that the so-called “Fallen Angels” of credit presented a persistent anomaly, backed by solid reasoning and academic support – which is one of the acceptable definitions of a “factor”. It helps that data providers such as Bloomberg Barclays have Fallen Angels indices. They are corporate fixed or floating-rate income instruments which have been downgraded from investment grade to high yield. The anomaly is that they persistently outperform the broader high-yield market segment for a time after the downgrade.
One would ordinarily think that such an anomaly would be quickly arbitraged away, but not quickly enough, apparently.
Over the 15 years between March 2005 and March 2020, the Bloomberg Barclays US Fallen Angels (3% cap) Index has outperformed all of the major fixed income indices – including emerging market debt, US high yield in general, US muni-bonds, US aggregate credit and global aggregate credit – but for a bit more risk (volatility). It has also outperformed the S&P 500 equities index, emerging market equity, and US small caps with lower risk.
Benson, who has been involved in fixed income management for the whole of his career, joining Mellon Capital in San Francisco in 2005 and before that spending several years at PIMCO in Newport Beach – says: “They typically provide equity-like returns with bond-like risk, while consistently outperforming broad high yield.” Also, the current timing is perfect for new entrants given expectations of elevated downgrade activity, which has historically led to outperformance. US Federal Reserve support may also mitigate downside risk, he says.
In April this year the Fed announced plans to expand its bond-buying program to include high-yield bonds, increasing the program to US$750 billion. Coincidentally, that is about the amount in the Fed’s first quantitative easing of US monetary policy in reaction to the global financial crisis in 2008. As an aside, the late Steve Jobs, founder of Apple Inc, who was a very good communicator, castigated a room-full of financial types for generally being poor communicators. He said the figure $750 billion rolls easily off the tongue for bankers and fund managers but doesn’t demonstrate the enormity of the sum. They could say, to impress an audience, words to the effect: if you were to receive $1 million a day to spend, every day since the birth of Christ, that’s roughly $750 billion ($737 billion to be precise).
The Fed program will look at high yield instruments with maturity of five years or less. The expansion includes companies that were investment grade as of March 23 and have subsequently fallen to high yield, as long as they are still BB rated or better. This includes several high-profile downgraded companies, Benson says “While the majority of buying will likely be in the investment grade space, the expanded program now includes high yield ETFs,” he says. There are several new Fallen Angel ETFs listed in the US. The total assets under management of five of the majors have risen from $US111 million to just over US$1 billion in the six months to June this year.
Of the five main equity factors – value, momentum, quality, size and carry – Mellon uses three for its smart-beta style Fallen Angels strategy. It doesn’t use carry or size factors. And with the others there are nuanced differences between their usage compared with equities. For instance, Benson says, with quality, on the credit side, there is not the same level of discrimination towards poor quality issues during periods of high volatility, which is often accompanied by indiscriminate selling. “But quality can still protect a portfolio in larger downturns,” he says. “With value, fixed income managers look more at relative value, comparing like-for-like among bonds to determine which ones are cheaper than others… Value on the credit side is more about mispricing. It’s quite different from the equity side where value is commonly assessed by comparing market values to book values.”
The main reason Mellon doesn’t typically include size in its suite of factors, although Benson says it’s an interesting and important factor, is that most strategies tend to disregard the very high transaction costs, where bid/offer spreads can be multiplied exponentially for smaller issuance sizes.
He says that he has never seen more appetite for the strategy in his career than in the current environment. “It goes hand in hand with market demand [for smart beta]. For a long time, people thought it was the same as the active-versus-passive debate. People are now aware that there is a big part in between. Clients want a positive end result net of costs and fees.”
– G.B.
