Beyond Junk

Ah, fallen angels … not the mythological kind that sprouted wings and took a cosmic tumble, but bonds that once proudly wore the "investment grade" badge before being unceremoniously downgraded to high-yield territory. Like the straight-A student who discovered parties in senior year, these bonds have an interesting story to tell.

Today, we're diving into the iShares Fallen Angels USD Bond ETF (FALN), a fund that swoops in to scoop up these corporate bond misfits. With its shiny Gold Medalist rating from Morningstar and $1.73 billion in assets under management, FALN has become the popular kid in the fallen angel class.

What Makes FALN Unique

While most high-yield bond funds are out chasing any company willing to pay juicy interest rates (including those that have been junk since birth), FALN is more discerning. It exclusively dates bonds that once held investment-grade status before their fall from grace. It's like choosing to hang out with people who once had their act together, theoretically, they might get it back someday.

Anatomy of a Fallen Angel

Let's break down how these corporate bonds earn their wings, or rather, lose them. It starts with a respectable investment-grade company (rated BBB- or higher) that hits a rough patch. Perhaps they've made an ill-advised acquisition, faced an industry downturn, or found themselves with too much debt on a diet of shrinking revenues. The major rating agencies, Moody's, S&P, and Fitch, playing the role of strict parents, review the company's financial report card and deliver the fateful news: "We're very disappointed in you. You're now a BB+ or lower."

That moment of downgrade creates a market theater worthy of Broadway. Many institutional investors – pension funds, insurance companies, and certain mutual funds – operate under mandates that forbid them from holding non-investment grade securities. When the downgrade hammer falls, these investors must sell, often regardless of price. It's like a financial version of musical chairs, except when the music stops, everyone has to change seats at once.

The Fallen Angel Opportunity

This forced institutional selling creates the magic behind FALN's strategy. These technical pressures often push fallen angel bond prices well below their fundamental value. Studies from PIMCO and other fixed income heavyweights suggest that fallen angels are systematically underpriced at the time of downgrade, with price declines averaging 5-10% beyond what fundamentals would justify. As a vulture investor might say: "Your mandate restriction is my market opportunity."

Historical data backs this up. Over the past 25 years, fallen angels have outperformed the broader high-yield market by approximately 1-2% annually, with extreme outperformance during recovery periods. It seems that markets tend to overreact to downgrades, creating a persistent inefficiency that FALN aims to harvest.

FALN tracks the Bloomberg US High Yield Fallen Angel 3% Capped Index, which is just a fancy way of saying it follows fallen angel bonds while making sure no single issuer throws too wild a party in the portfolio. Behind this ETF stands BlackRock/iShares – the Goliath of the investment world, managing more money than some countries' GDP. (No pressure, fund managers.)

Index Methodology: The Rules of Engagement

The index rules create a systematic approach to capturing the fallen angel premium. To be included, a bond must:

1. Has been rated investment grade by at least one major agency when it was issued

2. Currently be rated high-yield by two of the three major rating agencies

3. Have a minimum face value of $150 million (no small-time players)

4. Have at least one year until maturity (no almost-expired bonds)

5. Be fixed-rate (no floating-rate shenanigans)

6. Be USD-denominated (keeping it domestic)

The index rebalances monthly, capturing newly downgraded bonds relatively quickly, often when they're still in the "oversold due to forced selling" phase. The 3% issuer cap prevents any single troubled company from dominating the portfolio, which is particularly important when large companies get downgraded. When Ford Motor Company lost its investment-grade status in 2020, for example, it immediately became the largest fallen angel in history, with over $35 billion in affected debt.

The BlackRock Advantage

BlackRock's massive scale gives FALN several structural advantages over smaller competitors. With $10+ trillion in total assets, BlackRock has unparalleled bond market access, often serving as a primary market maker. This translates to lower trading costs, better execution, and the ability to participate in large fallen angel situations when smaller funds might be crowded out.

The firm's fixed income desk employs hundreds of credit analysts globally, providing research coverage that smaller shops can't match. While FALN is passively managed, this research infrastructure helps BlackRock optimize trade execution and sampling strategies when full index replication isn't practical.

Rising Stars: The Upside Potential

Perhaps the most compelling aspect of the fallen angel strategy is the potential for "rising stars" – bonds that get re-upgraded to investment grade. When this happens, the same technical factors work in reverse: institutional investors suddenly become eligible buyers, creating price appreciation beyond fundamental improvements.

Companies like Kraft Heinz, Netflix, and Tesla have all worn the fallen angel label at some point before cleaning up their balance sheets and regaining investment-grade status. When Netflix was upgraded to an investment grade in 2022, for instance, its bonds appreciated approximately 7% in the month surrounding the announcement.

In essence, FALN gives investors access to a niche of the credit market with uniquely favorable characteristics – bonds that may be temporarily down on their luck but come from good financial families. It's bottom-fishing with a pedigree, or as sophisticated bond investors might say, "buying the dip with structural tailwinds."

Portfolio Composition

Peek under FALN's hood, and you'll find a bond collection that's like a reformed troublemakers club:

• 81.08% BB-rated bonds (the "we're-not-that-bad" tier of high yield)

• 7.52% B-rated bonds (the "okay-we've-got-some-issues" crowd)

• 10.10% Below B (the "we're-really-going-through-something" group)

FALN is playing almost exclusively in the corporate bond sandbox (98.91% of holdings), apparently not interested in government drama or municipal politics. With an effective duration of 4.58 years, it's neither sprinting nor marathon-running through the interest rate landscape.

Performance Analysis

If FALN were a student, its report card would be taped to the refrigerator. Since inception, a $10,000 investment would have grown to a respectable $17,386, outperforming both its high-yield category peers ($15,101) and its index ($16,378).

What's interesting about FALN is that it's not just a one-hit wonder. In 5 of the last 8 calendar years, it's landed in the top half of its category, with standout performances in 2020 (1st percentile) and 2022 (9th percentile). It's like the consistent friend who doesn't always win the race but rarely finishes last.

Income Potential

You're probably not eyeing a high-yield bond ETF for its amazing capital appreciation potential. You want income, and FALN delivers a respectable 7.49% yield to maturity. That's not exactly winning the lottery, but in a world where banks still think 3% interest is being generous, it's nothing to sneeze at.

FALN pays its dividends monthly (how considerate!) and has maintained a relatively stable payout history. The most recent monthly dividend was $0.1538 per share, which annualizes to around 6.34% at current prices. Not too shabby for a fund that doesn't require you to wade into the murky waters of the junk bond swamp.

Risk Assessment

No free lunch in investing, folks! FALN's yield comes with risks, but fewer than you might expect from something with "high yield" in its description.

With a standard deviation of 5.38 (compared to the median ETF's 12.56), FALN is significantly less volatile than many of its peers. It's like driving a moderately sporty sedan instead of a Formula 1 car, still exciting, but less likely to wrap around a tree.

The fund's maximum drawdown during tough times was 17.82% – not a pleasant experience, but considerably better than the bloodbath some high-yield funds experienced during market tantrums.

Cost Structure

With an expense ratio of 0.25%, FALN charges 25 cents annually for every $100 you invest. That's in the cheapest quintile among its peers – practically the dollar menu of high-yield bond ETFs. BlackRock could charge more given this fund's specialized nature, but apparently, they're feeling generous.

Current Market Context

As of May 2025, we're in an interesting rate environment. The yield curve has normalized after its previous inversion, and there are expectations that the Federal Reserve might begin its rate-cutting cycle.

For FALN, this could be a Goldilocks scenario – not too hot or cold. Lower rates generally benefit bond prices, while economic stability keeps default rates in check. However, credit spreads have narrowed to near historical lows, suggesting investors aren't demanding much premium for taking on additional risk. That's either a sign of market confidence or collective delusion – only time will tell!

Investment Case

So, who might want to invite FALN to their portfolio party? Let's roll out the red carpet for its ideal dance partners:

The Income Hunters

FALN's 6.34% trailing twelve-month yield looks like a refreshing oasis for the yield-starved investor wandering the barren desert of Treasury returns. While investment-grade corporate bonds are sipping modest 4-5% yields, FALN offers a meaningful upgrade without forcing you to venture into the truly scary neighborhoods of the bond market.

The Value Detectives

There's a compelling case that fallen angels are the misunderstood teenagers of the bond world – going through a rough patch but with potential for redemption. Research from Morningstar and others suggests fallen angels historically outperform original-issue high yield bonds by approximately 1-2% annually over complete market cycles. Why? These companies typically:

• Have stronger asset bases built during their investment-grade days

• Face stronger incentives to regain their investment-grade status

• They are often larger, more established businesses than perpetual high-yield issuers

• Experience forced institutional selling during downgrades, creating price dislocations

The Tactical Allocators

If you're the type who enjoys a bit of tactical allocation (without going full day-trader), FALN offers interesting timing opportunities. Consider deploying capital to fallen angels:

• During credit market stress, when spreads widen dramatically

• After major ratings downgrade waves, create institutional selling pressure

• When economic recovery seems likely but hasn't yet been fully priced in

• As part of a barbell strategy paired with short-term Treasuries

The Portfolio Recipe

How much FALN is the right amount? Like hot sauce, the answer depends on your tolerance:

• Conservative Portfolio: 5-10% allocation, paired with 70-80% investment grade and 10-15% Treasuries

• Balanced Portfolio: 10-20% allocation, combined with 50-60% investment grade and 20-30% other income assets

• Aggressive Income Portfolio: 20-30% allocation, alongside other high-yield assets, preferred stocks, and dividend equities

FALN works best when it's playing a supporting role, like the quirky character actor who steals scenes but shouldn't carry the whole movie. A 15% allocation in a $100,000 portfolio potentially generates about $950 in annual income while keeping overall portfolio volatility in check.

Time Horizon Matters

FALN isn't for the weekend fling investor. This ETF rewards those committed to a 3+ year relationship, giving time for:

• Credit improvement cycles are set to play out

• Interest income to compound and offset any price volatility

• Potential rating upgrades within the portfolio to materialize into price appreciation

The Not-So-Perfect Match

FALN might not be the ideal date for:

• Retirees needing absolute stability of principal

• Short-term parking of cash (under 1 year)

• Those who can't sleep at night with any possibility of negative returns

• Investors who panic-sell at the first sign of market turbulence

In short, FALN works best as the spicy but not overpowering ingredient in your fixed-income recipe, adding flavor without burning down the kitchen. Limit your serving to a sensible portion of your bond allocation unless your financial pain tolerance rivals a competitive hot wing eater's.

Potential Drawbacks

FALN isn't all halos and harps. Let's remove the rose-colored glasses and examine the potential downsides more closely:

Economic Recession: When Angels Fall Further

If economic conditions deteriorate significantly, fallen angels face a particularly challenging path. Unlike established high-yield issuers who've weathered multiple downturns, many fallen angels are experiencing their first identity crisis as junk-rated entities.

Recent history provides a sobering example: during the 2020 COVID crisis, high-yield default rates jumped to 4.5-5%, but specific sectors saw much higher rates. Energy fallen angels, for instance, experienced default rates approaching 14%. FALN's relatively high exposure to sectors like consumer discretionary (including retail) and communications could become problematic in a consumer-led recession.

Unlike investment-grade bonds, which might just see temporary price declines during economic stress, high-yield bonds face existential threats. A BB-rated issuer isn't just risking a price drop—it's risking bankruptcy. While FALN's historical default rate has been below the broader high-yield market, it's not immune to credit events that can permanently impair capital.

Concentration Risk: The Fallen Angel Echo Chamber

FALN's specialized mandate is both its charm and its challenge. By focusing only on fallen angels, the fund inadvertently creates concentration risks that broader high-yield funds avoid:

• Sector clustering: Fallen angel waves tend to hit specific sectors all at once (energy in 2015-2016, retail in 2017-2019, travel and leisure in 2020)

• Similar downgrade catalysts: Companies downgraded for similar reasons often face similar recovery challenges

• Correlated recovery timing: Fallen angels in the same sector typically need similar economic conditions to improve

While FALN holds 163 individual bonds, its adequate diversification is more limited than a traditional high-yield fund with 900+ issues across the full spectrum of non-investment grade credits. It's like having a party with 163 guests working in the same industry—diverse individuals, but with highly correlated job security.

Interest Rate Risk: The Duration Dilemma

With an effective duration of 4.58 years, FALN carries meaningful interest rate sensitivity. If rates unexpectedly rise by 1% across the yield curve, the fund could experience a price decline of approximately 4.58% (before accounting for income or credit spread changes).

This duration risk becomes relevant as we consider:

1. The historically low interest rate environment, despite recent increases

2. Persistent inflation pressures that could force central banks to remain hawkish

3. Growing government deficits that might eventually push term premiums higher

FALN's duration is actually longer than many broad market high-yield funds (which often average 3-4 years) because fallen angels typically issued longer-dated bonds during their investment-grade days. That extra duration adds another layer of volatility during rate-shock periods.

The BB Balancing Act: One Foot on the Ladder, One in the Pit

FALN's heavy concentration in BB-rated credits (81.08% of the portfolio) creates a unique risk profile. These credits occupy the awkward teenage years of the bond world—no longer respectable investment grade, but not rebellious enough to be deep high-yield.

During recessions, rating agencies turn particularly trigger-happy with downgrades. A BBB becoming BB (entering the fallen angel category) is concerning, but not catastrophic. However, when a BB becomes a B or worse, several adverse cascade effects occur:

• Many institutional investors face stricter limits on lower-rated credits, forcing additional selling

• Liquidity can evaporate faster for B-rated issues during market stress

• Financing options narrow dramatically, potentially creating cash flow problems

• Recovery rates after average significantly lower for B and CCC bonds than for BB issues

Historical data shows that during the 2008 financial crisis, about 18% of BB-rated bonds were downgraded to B or lower within 12 months. A similar wave could create substantial mark-to-market losses for FALN investors, even without actual defaults.

The Liquidity Lock: When Everyone Heads for the Exit

One underappreciated risk in high-yield bonds is liquidity deterioration during market stress. While FALN's $1.73 billion in assets provides reasonable liquidity in regular times, high-yield bond markets can quickly become one-way streets during panics.

In March 2020, high-yield bond ETFs briefly traded at discounts of 5-6% to their net asset values because the underlying bonds became so difficult to sell. During severe market dislocations, FALN investors could face similar disconnects between the fund's NAV and its trading price.

Remember that while FALN's average credit quality is higher than many high-yield funds, it's still fundamentally a junk bond portfolio dressed in slightly nicer clothes. Its volatility may be lower than some alternatives, but when risk aversion takes over the market, all high-yield categories tend to move in uncomfortable unison toward the exits.

Alternatives and Comparisons

If you're shopping around the high-yield neighborhood, you might also consider:

• ANGL: The closest comparison is VanEck Fallen Angel High Yield Bond

• HYXF: Another fallen angels ETF, but with a slightly different approach

• WEA: Western Asset Premier Bond Fund, a CEF alternative with a higher yield but using leverage

• HYLB: A broader high-yield ETF with more comprehensive market exposure

Conclusion

FALN offers an interesting middle ground in the fixed-income universe – higher yield than investment grade without diving headfirst into the riskiest segments of high yield. Its Morningstar Gold Medalist rating, solid track record, and reasonable expense ratio make it worth consideration for investors seeking to enhance their income without losing sleep at night.

As with any investment, your mileage may vary. But for those looking to add a touch of "fallen" dignity to their portfolio, FALN might earn its wings in your fixed-income allocation.

Remember: Past performance doesn't guarantee future results, but it's the best crystal ball we've got in this business.