A fallen angel is a security that, after being classified as an investment grade asset, presents a very significant decrease in value that leads it to quickly obtain the junk bond rating.
With fallen angel, we mainly refer to bonds (fixed income) issued by both public and private entities. However, it also applies to stocks (equities) that reached their maximum price in a given scenario and, since then, their price has fallen substantially.
Characteristics of a fallen angel
Among the main reasons outlined for the negative rating of these securities is the financial deterioration of the issuing entity. This can occur due to falling revenue or overestimation of future cash flow. Also, another reason may be the increase in debt to unsustainable levels. In practice, both elements can come together and generate a more intense impact.
It is important to note that the risk rating agencies are the ones who issue said rating for debt securities. Rating agencies such as Standard & Poor’s or Moody’s Investors Services, for example.
Another important characteristic is that, once the rating is lowered, the selling pressure increases. Therefore, it causes the price drop to intensify. These decisions may be due to market panic, sale of mutual fund positions by agreement, or a combination of both. In the opposite case, if the bond were to recover, when the rating was changed, the buying pressure would increase. In conclusion, rating agencies tend to enhance the volatility of the price of securities.
Risk and investment potential of a fallen angel
Fallen angel bonds can represent high yield bonds when it is considered that the issuer can recover from the crisis. In fact, in cases of moderately strong companies, they are considered to be of higher quality than those with average high performance. This, due to the expectation that they can recover the investment grade once the situation has passed.
Therefore, it is likely to observe that, after the downgrade, the values increase in price. This, caused by buying pressure from investors for speculative purposes.
However, this action represents a high risk. For example, suppose an organization is affected by another that offers a better product or service. The appearance of competition with better projections or technology can cause bonds or stocks not to recover. Therefore, the premise is fulfilled that, in search of high returns, one is exposed to greater risk.
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