A Trade That Surged 40% on Pandemic Misery Risks Stalling

Even as the world nears a vaccine and the economic outlook brightens, a booming trade that bets on bonds from some of the companies hit hardest by the pandemic is at risk of stalling.

Investors have poured a record $2.2 billion this year into exchange-traded funds that buy so-called fallen angels, or debt rated investment grade that has been downgraded to junk. History shows the price of these securities tends to fall too far too fast, and the idea is to ride the rebound — or even the bounce back to high-grade for some names.

It’s been a rewarding trade for much of the year, with a U.S. index tracking the investing style at an all-time high after a near 40% surge since the depths of the March selloff. A slew of downgrades followed by central bank bond-buying and gradually improving economic prospects made for ideal conditions.

The worry now is fewer securities are set to be relegated to junk as growth recovers, and those which do get cut are less likely to be oversold thanks to spirited risk appetite. All that reduces the potential for money managers to profit from downgrades and discounts.

The prospect ofan end to Federal Reserve emergency programs adds another headwind to the trade.

“At this point, most of the rally, most of the trade is behind us,” said Geof Marshall at CI Investments in Toronto, who has tripled exposure to fallen angels in hisSignature High Yield Bond Fund since March. “Bond picking is going to be more important than timing the last leg of the trade.”

Fallen angels have been enjoying unprecedented popularity thanks to the Fed, which said in April it would include some downgraded securities in its emergency bond-buying program.

That added the ultimate backstop to debt which had already shown a historical ability to regain investment-grade status as companies cut leverage or boost cash flow. Over the past decade, downgraded names have far outperformed regular peers, according to analysis by Marty Fridson of Lehmann Livian Fridson Advisors LLC.

Read more:Credit Faces Loss of Momentum on Prospect of Fed Steps Ending

Now, the backstop is at risk. U.S. Treasury Secretary Steven Mnuchin on Thursdayrequested that emergency liquidity including primary and secondary market corporate credit facilities introduced earlier in the year expire as scheduled on Dec. 31. The central bank objected to the instruction, but it puts the continuation of measures that helped stave off a massive wave of bankruptcies in doubt.

Marshall at CI says betting on companies to bounce back from virus lockdowns is a surer play than wagering on a rebound after the global financial crisis or the 2015 energy crash. But it is going to be harder to make money.

A glance at some of his own trades shows how many rebounds have already taken place.

Bonds of Occidental Petroleum Corp. collapsed to 47 cents on the dollar following their downgrade to junk in March. They’re now trading at about 84 cents. He also bought debt from Kraft Heinz Co., Cenovus Energy Inc. and Expedia Group Inc., all of which have bounced back.

Most of those names are among the top holdings of the $3.5 billion VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL) and the $376 million iShares U.S. Fallen Angels USD Bond ETF (FALN).

Inflows to the funds in 2020 have more than doubled their assets and trading volumes. With an 11% return, FALN is one of the best-performing credit ETFs year-to-date. It hasn’t had a single day of outflows since April.

The ETFs work by buying newly relegated debt each month and benefiting as prices recover. But that strategy’s effectiveness could suffer if rating actions dwindle and bonds get harder to come by.

October saw a second monthly decline in bonds at risk of falling out of investment grade, according toBloomberg Intelligence. Collectively, the main agencies — Moody’s Investors Service, Fitch Ratings and S&P Global — had cut the bonds of just 56 North American companies to junk in the second half of the year through Thursday. In the first half of 2020 it was more than 140.

With fewer angels on the way, Marshall only wishes he’d bought even more in March.

“We captured a lot of the trade,” he said. “But not enough.”

— With assistance by Molly Smith

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