Fallen Angel

What Is a Fallen Angel?

A fallen angel is a bond that was once rated as an investment-grade rating by the major credit rating agencies but has since been downgraded below investment grade. Such bonds are now considered speculative and are often called high-yield bonds or junk bonds. The term describes a change in status rather than a particular type of security. The same bond can become a fallen angel after a downgrade, and the label usually stops applying if it is later upgraded back to investment grade.

How the Downgrade Happens

Rating agencies assess how likely a borrower is to repay its debt. A downgrade usually follows a decline in the issuer's finances, such as lower profits, heavier debt, weaker cash flow, or a serious legal or operational setback.

A move from investment grade to high yield can be especially disruptive because some institutional investors, such as certain pension funds and insurers, are limited by their own mandates or rules from holding below-investment-grade debt. Those investors may need to sell, which can push the bond's price down and its yield up.

Why Fallen Angels Matter to Investors

Because prices can fall sharply around a downgrade, fallen angels often trade at a discount to face value, and their yields can rise well above what they offered before. The gap between their yield and that of safer government debt is measured as a credit spread. Some investors focus on this category because they expect the price to recover if the issuer improves. Others see the higher yield as payment for taking on greater default risk. Either way, the rating alone rarely tells the full story, so analysts usually examine the issuer's cash flow, debt levels, and likely financial path.

Risks and Limitations

Fallen angels carry more risk of default than investment-grade bonds, and a downgrade often signals real problems in the issuer's business. Prices may keep falling after a downgrade, and selling a position can be difficult in stressed markets. Funds that track investment-grade bond indexes may also have to sell when a bond leaves the index, which can move prices more than the company's fundamentals alone would suggest. Because ratings can lag behind events, they are best treated as one input among several.