Investors have opted for high yield over fallen angels ETFs due to the asset class’s shorter duration risk profile amid record inflows into fixed income ETFs.
High yield ETFs gathered $3.7bn net new assets across 45 Europe-listed strategies versus $130m inflows into five fallen angels ETFs in 2023, according to data from Bloomberg Intelligence.
This equates to $72m per ETF across high yield products while fallen angels strategies captured around $22m per ETF.
Focusing on BlackRock, the largest ETF issuer within each product class, the $1.1bn iShares Fallen Angels High Yield Corp Bond UCITS ETF (WING) comprised 82% – $106m – of all fallen angels ETF inflows last year.
Meanwhile the $7.5bn iShares € High Yield Corp Bond UCITS ETF (IHYG) captured $1.3bn net new assets.
The reason for this disparity has been investors seeking to reduce duration exposure within the higher-risk portion of their fixed income allocations.
Sebastien Cabral, research associate at Bloomberg Intelligence, noted high yield UCITS ETFs have an average duration of 3.42 years versus 4.68 years for fallen angels ETFs.
Why are investors so down on fallen angels?
While investors funnelled $3.8bn into the $7.4bn iShares $ Treasury Bond 20+yr UCITS ETF (IDTL) in 2023, it appears high-quality US Treasuries were the tool of choice for duration bets.
Kamil Sudiyarov, product manager at VanEck, which launched the $7m VanEck US Fallen Angel High Yield Bond UCITS ETF (USFA) last September, explained fallen angel indices tend to overweight higher rated issuances versus high yield indices, owing to bond issuers formerly being rated investment grade.
“Normally, the higher the rating of the bond, the higher its duration is, because your cash flows are smaller and more dependent on the discount rate you have,” Sudiyarov explained. “For high yield, it is the other way around – the main source of risk is credit risk.”
He added the higher average quality and duration of fallen angels ETFs results in higher exposure to interest rate fluctuations versus broad high yield strategies.
“In an environment where markets are repricing the number of cuts to lower than previous expectations, high yield is potentially more attractive as the price is not as dependent on the interest rate moves as the higher-rated bonds,” he said.
Second order risks?
Sudiyarov also noted the nature of fallen angels – as bonds which have had their ratings downgraded – means they tend to offer exposure to different downtrodden sectors at different intervals.
“For instance, after 2008 it was banking while declining oil production in 2014-2015 meant there were lots of issuances from energy companies,” he continued. “There are still a lot of energy companies in fallen angel indices today versus high yield.”
However, he noted there are risks within high yield such as the “parabolic relationship” between interest rates and default risk.
“The lower the rating, the less the duration risk, but there are also second order risks,” he argued. “If borrowing costs become so prohibitive, it could affect balance sheets in a negative way and increase the default risk.”
Overall, he concluded default risk within high yield has diminished as spreads appear “quite compressed” versus early 2023. Worries of an economic hard landing have subsided, meaning the narrative of an overly high debt burden is not as prevalent as the narrative about the interest rate sensitivity of cash flows.
