Fallen Angels: How do bonds react to a downgrade?

A ‘buy and maintain’ credit strategy can be an effective way for long-term bond investors to gain exposure to the returns generated from a broad, diversified portfolio of investment grade bonds, in a less volatile, low-cost way.

How do low cost credit strategies deal with ‘fallen angels’?

Passive funds that track Investment Grade credit indices are generally required to sell a bond at the point it is downgraded to High Yield, and thus excluded from the index. Historically, this has tended to be the point where a bond’s credit spread peaks and its price troughs, resulting in the highest crystallised loss. As a result, not only does a typical passive fund sell bonds that may never default – it also sells them at the worst possible time.

Bonds suffering this fate are commonly referred to as ‘fallen angels’, and their prices generally recover shortly after the downgrade, as the investor base shifts from Investment Grade to High Yield.

Buy and maintain strategies do not slavishly adhere to the inefficient rules of passive investing, and do not engage in unnecessary forced selling. At AXA Investment Managers our buy and maintain portfolios are permitted to hold a modest number of fallen angels, as long as we believe the fundamentals remain strong and that they remain ‘money good’.

This is one of the ways buy and maintain strategies avoid unnecessary trading and minimise performance leakage compared with those subject to forced-selling rules.

Watch Senior Fund Manager Lionel Pernias discuss ‘fallen angels’ in his video: AXA IM's approach to low-cost credit investments