Fallen angel

A fallen angel is an issuer, or a bond, that was investment grade and has been downgraded below BBB minus. The reverse move, from high yield up into investment grade, is a rising star.

What makes the label worth having is the technical effect rather than the credit event. Investment grade bond indices exclude bonds below the line, and many institutional mandates prohibit holding them, so a downgrade forces sales by holders who are not expressing a view on value at all. That selling is price insensitive and concentrated in the weeks around index rebalancing.

The consequence is that the price move on a downgrade contains two different things: the fundamental repricing of a worse credit, and a temporary technical from forced sellers meeting a smaller pool of buyers. Distressed and crossover funds exist partly to take the other side of the second one, and whether a spread retraces after the forced sellers are done is the evidence for which effect dominated.

It also explains issuer behaviour that looks irrational from a pure valuation standpoint. Companies at the bottom of the investment grade band cut dividends, sell assets and issue equity to hold a rating, because the cost of falling through the line is paid on every future issue, not just the current one.