Financial Education

Bonds may either be issued as speculative grade bonds (original issue)or become so following a rating downgrade (fallen angels). In either case, their risk-adjusted returns should be similar. However, in an article published in the Fall 2007Journal of Portfolio Management Fridson and Sterling point out that fallen angels have historically delivered far higher risk-adjusted returns, and discuss several explanations for an apparent market inefficiency.

The authors find the correlation between fallen angels and original-issue speculative grade debt to be lower than that between Treasuries and investment-grade corporate bonds, suggesting dissimilar attributes and below the threshold normally used to classify securities as part of the same asset class.

Possible reasons for the disparity include:

• Lack of investor awareness, given that the primary high-yield index only recently began breaking out the performance of the two categories
• Emphasis on security selection and possible overconfidence among managers that they can pick the superior original-issue bonds
• Investability – fallen angels account for just 30% of available speculative-grade debt and trade infrequently
• Lottery-like returns for specific original issue bonds
• Yield appeal due to higher yields typically found with original issue bonds

For more information, see all articles on: Active Management, Investing in Distressed Securities, Investing in bonds, Investment Returns, Performance Measurement, Research, Risk Management

See also:

Breakeven Spread Analysis

Sources of Excess Return in International Bond Portfolios

Primary Capital Markets

Immunizing a Fixed Income Portfolio Using Futures

Yield Elasticity