Effects of Credit Downgrade Path on Fallen Angel Returns

Abstract

Fallen angel bonds provide an opportunity for high yield bond investors for increased returns. Dor and Xu, in "Fallen angels: characteristics, performance, and implications for investors", compare two portfolio strategies of exclusively fallen angels bonds with different initial buy dates of the bonds. With their "3-Month Reversal" portfolio over performing "Buy-All" portfolio. We replicate these portfolios, as 3 Month and JNK Date respectively, with a newer more recent time period of 2008-2022 and saw this overperformance of 3 Month portfolio outperforming JNK Date portfolio continue which align with Dor and Xu's findings.

Added with this we also studied the affect of how quickly the deterioration of the credit rating, prior to their credit rating event, of fallen angel bonds would affect returns. By breaking these "Credit Rating Slopes" in quartiles we presumed that the shallowest quartile would have the largest Sharpe Ratio and thus overweighting these bonds would overperform an even weighting fallen angel portfolio. But the opposite held true with the steepest quartile providing the highest Sharpe Ratio and portfolios that overweighted these bonds overperformed their benchmarks. However these improved "slope" portfolios overperformance is not as extreme as the overperformance going from a universal high yield portfolio to an exclusively fallen angel portfolio.