Why bond managers are positive on ‘rising stars’

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Corporate bonds that fell into high yield just under two years ago are now on their way to investment grade, becoming what are known as “rising stars” and creating opportunities for bond managers.

In Q1 2016, 51 companies became so-called fallen angels, dropping from investment grade to high yield, compared to 45 in the whole of 2015. In the US, the majority were in commodities sectors, while globally banking was the most represented sector.

Bond managers argue there are now opportunities in so-called rising stars, which move from high yield to investment grade.

Western Asset Macro Opportunities fund manager Mike Buchanan says it is one of the most unique environments for rising stars in his almost three decades in the bonds markets.

Almost 20 per cent of BB-grade bonds have the potential to move into investment grade over the next 18 months, says Buchanan.

Many of the bonds had only slipped into high yield in late 2015 or early 2016 becoming so-called “fallen angels”.

“It turns out the best trade last year from the start of 2016 was going long those fallen angels,” says Buchanan, who says they were one of the few managers to buy into the trade.

A lot of investment grade managers were selling while high yield investors were anticipating a wave of downgrades, says Buchanan.

“We started to see these valuation anomalies that were head-scratching to say the least and showed us there were these huge opportunities in fallen angels. In hindsight you wish you would have been more aggressive.”

Buchanan says many of last year’s fallen angels are now benefiting from stronger commodity prices and an aggressive drive to return to investment grade by paying down debt with free cash flow.

The fund holds high yield issues from Williams and Freeport-McMoRan, which Buchanan reckons could move to investment grade, noting that an upgrade can reduce spreads 75 to 125 basis points.

Many rising stars are in mining and metals, but he names Haines and Levis as others that could graduate into investment grade.

Hermes co-head of credit Fraser Lundie says shareholder-friendly activity is taking a backseat to balance sheet repair at many of these companies. “We see this trend continuing, allowing for some fallen angels to become rising stars.”

Lundie points to Brazilian based iron ore producer Vale as a company promoting credit-friendly strategies.

The BofA Merrill Lynch US Fallen Angel High Yield Index has returned 12 per cent over the last year. Its US High Yield index has returned 9.9 per cent over that period.

Invesco launched the PowerShares US High Yield Fallen Angels Ucits ETF on the London Stock Exchange last September.