Francis Rodilosso’s fund of fallen angels buys what others have to sell and sells what others have to buy.
Are you prepared to bet against the market—indeed, against your instincts? Try doing this: At a time when a recession seems imminent and interest rates are rising, invest in junk bonds.
Francis Rodilosso runs the Van Eck Fallen Angel High Yield Bond ETF. For this $2.8 billion portfolio, he mechanically buys bonds as soon as they get downgraded from high-quality to junk and sells any that get upgraded from junk to high-quality. This is precisely the opposite of what any prudent manager of an “investment grade” bond portfolio does.
In the fallen angel junk pile: debt from such outfits as Bed, Bath & Beyond, Royal Caribbean Cruises and Transocean. Yuck.
But now look at the results. Over the past decade Rodilosso’s junk fund has averaged an annual return of 5.8%. The Vanguard Total Bond Market exchange-traded fund, which sticks to high-quality credits, has eked out only 1.4% a year.
FALLEN ANGEL YIELDS
The average yield to maturity of bonds that started out with good credit ratings and then slumped in quality is now fairly high, at 7.5%. But the 3.4% yield advantage over comparable Treasury bonds is only mediocre. The spread is "option-adjusted" — meaning, calculated after allowing for the damage done by bond call provisions.
Are we in, or about to be in, a recession? That is strongly suggested by how high short-term interest rates are in relation to long-term ones. If it occurs, this junk fund, like all junk funds, will suffer. Will interest rates continue their upward drift? They might. Rates shot up last year, and that did a lot of damage to the Van Eck fund and just about every bond fund.
You can, at any rate, tolerate a certain amount of risk when the coupon on the bond is fat enough. Rodilosso’s philosophy: “Go where the yield is.”
The yield on the fallen angels fund, as Morningstar calculates it, is 6.7%. That is better than 3 percentage points above the yield on U.S. Treasury bonds of comparable maturity. Three points of extra interest is enough to make up for some of the indigestion experienced by investors in junk.
Expect heartburn. Catching angels as they fall means buying into sectors on which the rest of Wall Street is gagging. Three years ago the Van Eck fund added bonds from Occidental Petroleum and Ford Motor as they tumbled in credit quality, no surprise given that the spot price of crude was about to hit zero and Ford was sinking into red ink.
Results: not bad. Occidental Pete and Ford, both still in the portfolio, have not recovered their investment-grade credit ratings, but they are keeping up with coupon payments. The Occidental bonds, bought at 75 cents on the dollar, have risen in price to 97. The fund has ridden the Ford 4.75% bond due in 2043 from 64 to 77.
On occasion a bond has gone up and out. Debt from EQT, the gas driller and distributor, came on board in 2020 at a price of 77. The bond regained its BBB- status two years later, making it too credit-worthy to retain. The fund exited at an average price of 106.
Some angels go the other way. When the fund opened in 2012, J.C. Penney was included. The sickly retailer eventually went bankrupt. The fund lost a bunch.
Somehow Van Eck Fallen Angles has managed to just make up, with winners like EQT and Occidental, the capital losses from duds. Its net assets per share figure is now dead even with where it was a decade ago. Contrast the Vanguard High Yield Corporate Fund, an open-end, and the SPDR Bloomberg High Yield Bond ETF: These much larger players both have eroding asset values.
How is it that excess returns to the fallen-angel strategy have persisted for so long? You’d think that hedge funds or other investors would copycat what Rodilosso is doing, leaving less money on the table for him. Indeed, they are probably doing just that.
But there is ample supply of the oversold bonds and ample demand for the recovered angels. That is because, to a large degree, the investors on the other side of the trades have their hands tied. A manager with a mandate to own high-grade bonds has to get rid of the junk sooner or later and replace it with high-grade bonds. Both these managers and Rodilosso do, however, have a little flexibility in the exact timing of their portfolio updates; that’s to make it hard for speculators to step in front of their trades.
A JUNK BOND FUND SAMPLER
Hundreds of funds specialize in debt from weak companies or sketchy parts of the globe. This is a small subset.
If the lurches up and down in corporate credits cause no sleepless nights for Rodilosso, that’s for two reasons. One is that his portfolio is dictated entirely by rules. If an issue exceeds a certain size and isn’t close to maturity, it is automatically added when it gets busted down in average credit quality, among several rating agencies, from investment grade (BBB- or better) to BB+ or less. So he need feel no remorse over the clunkers.
The other reason for equanimity about fallen angels is that Rodilosso, 54, has acquired a thick skin. He has spent much of his career tangling with debtors much more distressed than Ford.
After getting a degree in history from Princeton, with a focus on Latin America, and then an M.B.A. at Wharton, Rodilosso started out on a bond trading desk but soon grabbed an opportunity to analyze debt from South America. That continent abounds in principal haircuts and speculative recoveries. “In distressed situations there are two sides to credit analysis,” he says: “Ability to pay and willingness to pay.”
Unwillingness? Not an issue in the U.S., where we have a rule of law and bankruptcy courts, but very much an issue in emerging markets. If Argentina wants to stiff creditors, it will.
The collection of fixed-income ETFs that Rodilosso and three deputies oversee at Van Eck Associates includes two with securities from iffy locales: Emerging Markets High Yield Bond, which owns dollar-denominated bonds of foreign corporations, and J.P. Morgan EM Local Currency Bond, which owns sovereign debt payable in fiat money that has no reliable relationship to the dollar.
The local currency portfolio started 2022 with 5.7% of its assets denominated in rubles. Oh, dear. Still, that fund closed out the year down only 10%, not as much as the 13% loss on the gilt-edged U.S. total bond fund from Vanguard or the 14% loss on the fallen angels fund.
Go where the yield is, says our bond man. Where is that? “Credit and EM,” by which he means: debt from issuers less credit-worthy than the U.S. Treasury and debt from overseas markets less established than those of Japan and Europe.
You’ll find plenty of yield out there on the fringes of the bond market, along with plenty of risk. But then, U.S. government debt is risky, too. In last year’s crash the biggest damage was in long-dated, triple-A Treasurys, down 39%. Nothing ventured, nothing gained.
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