A Fallen Angel refers to a corporate bond that was initially issued with an investment-grade credit rating but has since been downgraded to a speculative or high-yield (junk) rating. This downgrade occurs when the issuer’s financial health deteriorates, raising concerns about its ability to meet debt obligations. The fall from investment-grade status to junk status can have significant implications for both bond issuers and investors.
How Fallen Angels Work:
Initial Issuance:
Fallen Angels begin their journey as investment-grade bonds, typically issued by companies with solid creditworthiness.
Investors are attracted to these bonds for their higher credit ratings, which imply a lower risk of default.
When a company faces financial challenges or economic headwinds, its creditworthiness may decline. Credit rating agencies, such as Moody’s or Standard & Poor’s, may then downgrade the bond to junk status, reflecting an increased risk of default.
Market Impact:
The downgrade triggers a series of events in the market. Institutional investors, such as pension funds or mutual funds, often have restrictions on holding junk-rated securities, compelling them to sell these bonds.
Price Volatility:
The forced selling by institutional investors can lead to a rapid decline in the price of the Fallen Angel bonds. This price decline can result in higher yields for these bonds, attracting investors who are willing to take on the increased risk for the potentially higher returns.
Risks Associated with Fallen Angels:
The primary risk associated with Fallen Angels is the increased likelihood of default. Companies facing financial difficulties may struggle to meet their debt obligations, leading to losses for bondholders.
Market Liquidity:
The sudden downgrade of a bond can lead to a lack of liquidity in the market, making it challenging for investors to buy or sell these bonds at desired prices.
Interest Rate Sensitivity:
Fallen Angels, like other bonds, are sensitive to changes in interest rates. Rising interest rates can negatively impact the prices of existing bonds, potentially leading to capital losses for investors.
Sector and Industry Risks: Certain industries are more prone to experiencing Fallen Angels, especially during economic downturns. Investors concentrated in specific sectors may face heightened risks.
