FALN ETF: As Smooth As High-Yield Gets (NASDAQ:FALN)

Michael Vi Today’s focus shifts to the iShares Fallen Angels USD Bond ETF (NASDAQ:NASDAQ:FALN). We decided to assess the ETF’s prospects due to the embedded volatility in the bond market and the uncertainty surrounding the trajectory of credit risk. Moreover, the FALN ETF’s market value has increased by more than 5% in the past year, meaning numerous investors might want to reassess their exposure. Herewith is our take on FALN ETF. FALN ETF’s Recent Performance The following diagram shows that most of the FALN Bond ETF’s returns have arrived via dividends, dictating a holistic analysis. Moreover, a closer look at the FALN ETF’s recent price return illustrates cyclicality, bringing forth an opportunity to analyze it from an active vantage point. Data by YCharts Let’s conduct a fundamental top-down analysis to determine what the FALN ETF has in store for investors. FALN ETF: A Systematic Analysis For those unaware, high-yield bonds have various classifications. One classification is “fallen angels,” which refers to bonds that previously held investment-grade ratings but were downgraded to non-investment grade. The FALN ETF invests in fallen angels, hence its name. Its high-yield status means that credit risk has a large impact, which is confirmed by the vehicle’s option-adjusted spread. Aside: OAS is an excess spread over the treasury yield curve that accounts for credit risk. FALN Portfolio Metrics (iShares) Effective Duration Effective duration refers to a bond’s price sensitivity to a 1% parallel shift in the yield curve. To set the tone for the FALN ETF, let’s start by assessing the interest rate environment. The following diagram shows the U.S. Yield curve; a discussion follows. U.S. Yield Curve (worldgovernmentbonds.com) The U.S. yield curve has dropped in the past month, showing a parallel shift. The most likely cause is an expected decrease in inflation. However, the U.S. inflation rate has hovered in recent months, providing little to no evidence that the yield curve will experience an abrupt decline. Our premise extends to fundamentals, such as the fact that consumer confidence, business inventory demand, and PMI figures are volatile but not trending downward. Data by YCharts As the dot plot shows, interest rate uncertainty is high. In fact, we would be very surprised if an aggressive interest rate cut cycle occurred. U.S. Dot Plot (Bankrate) In essence, we expect short-term interest rates to remain level in the following quarters. However, to remain objective, we decided to do a sensitivity analysis of various scenarios that might occur. However, note that the influence of credit spreads and dividends is only incorporated later in the article. Scenario Analysis (Author’s Work) As a side, note the following. A positive duration means there is an inverse relationship between interest rates and the bond vehicle’s price. The formula used for the sensitivity analysis = – (Effective Duration x Change In Yield) + (0.5 x Convexity x Change In Yield^2). FALN’s closing price on 24/06/2024 was utilized as a base. Credit Risk Credit risk typically comprises default rates, losses given default, and illiquidity. Let’s start by analyzing the credit spread before moving into risk migration. Although having ticked up by about 18 basis points since May, Option-adjusted spreads have decreased by a staggering amount in the past year, suggesting the market believes that credit risk has abated. St. Louis Fed As established, the market believes credit risk has fallen since this time last year. However, we think fundamental credit risk and spread risk will skyrocket; here’s why. Firstly, trailing U.S. high-yield default rates have increased considerably in recent months. According to Fitch, High-Yield TTM default rates settled at 4.29% in May and 4.51% in April, a significant increase from 2.97% in January and 3.04% in February. According to our understanding, Fitch counts the number of defaults instead of value-based defaults. Nevertheless, the reported numbers show a sharp increase, which worries us. Furthermore, according to Polen Capital, recovery rates on high-yield bonds have averaged 38% for the past ten years. Recovery rate data is difficult to find. However, we expect a contemporaneous decrease in recovery rates (especially if default rates increase) as recent stagflation might have decreased collateral valuations and corporate earnings. Polen Capital, JPMorgan, Credit Suisse, ICE Lastly, bond market liquidity might be a problem. According to the Financial Times, a recent mismatch between buyers and sellers has dampened bond market liquidity. Moreover, high-yield bonds are lower on the liquidity spectrum, therefore enhancing their liquidity risk. As with the previous section, I embedded a sensitivity analysis for you. However, this time, it looks at credit spreads in isolation. The OAS chart shows that credit spread deviations can be smaller than yields, so we downsized the various scenarios. Sensitivity Analysis (Author’s Work) Here are a few factors worth noting regarding the model. Spread duration was calculated = (FALN’s OAS/Yield to Maturity) x Modified Duration. The Modified Duration was derived = Effective Duration x YTM Once again, FALN’s closing price on 24/06/2024 was utilized. Credit Migration To gain a more granular understanding of FALN ETF, we decided to assess its portfolio issuers. About 80% of the ETF’s issuers have BB ratings, meaning they’re borderline non-investment grade. We believe this vehicle’s spread duration is moderate, and its borderline non-investment grade exposure likely explains why. iShares The following diagram illustrates FALN ETF’s sectoral exposure; a discussion follows. Sectoral Exposure (iShares) Another talking point is non-financial company interest coverage ratios, which are salient to determining tranched credit risk. It is shown that non-investment grade coverage ratios settled below 4x last year, which isn’t too bad, in our opinion. Interest rates have remained high in 2024, and U.S. corporate earnings have slid by about 62 basis points year-over-year. As such, we don’t think corporate interest coverage ratios have improved since last recorded. Nevertheless, FALN ETF is sector diversified, allowing it to navigate some of the aforementioned risks as sectoral performance isn’t perfectly correlated. Moreover, the ETF has little exposure to the banking industry, making for easier analysis as liquidity ratios are released sparsely. S&P Global FALN ETF is an unconcentrated ETF, meaning issuer-specific analysis is challenging. However, we collated data from nine of its top ten holdings, which span more than 20% of the ETF’s portfolio, communicating the salient features of FALN ETF’s portfolio. We think the ETF’s primary constituents have good EBIT margins. Moreover, we believe that most of FALN ETF’s speculative grade status derives from tranche attributes instead of issuer-level problems. Sure, some of the issuers have lean EBIT margins. Nonetheless, they’re mostly mature companies that have survived numerous cyclical downturns. Stock EBIT Margin Telecom Italia (OTCPK:TIIAY) 8.57% Nordstrom (JWN) 3.34% Service Properties Trust (SVC) 11.34% UniCredit (OTCPK:UNCFF) 42.72% (Net Income) Vodafone Group (VOD) 9.46% Newell Brands (NWL) 6.09% Equitrans Midstream (ETRN) 47.47% Walgreens Boots Alliance (WBA) 1.14% Western Digital (WDC) -8.49% Click to enlarge Source: Seeking Alpha We think FALN’s downgrade risk is minimal. According to its mandate, the ETF might recurringly invest in high-yield bonds. However, we don’t think the ETF will suffer from price impact due to mass downgrades of its existing issuers’ high-yield bonds. Potential Return To Investors All-In We used a factor model to forecast FALN ETF’s potential one-year return. Our yield and credit premium findings were combined with other metrics to amalgamate a price target. Although we can’t be certain, we anticipate FALN ETF to gain by approximately 10.55% within the next twelve months. Alternatively, a slightly worse scenario could lead to an all-in return of 4.13%, while a best-case scenario could deliver an all-in return of 19.67%. 1- Y Expected Return (Author’s Work) Herewith, a few considerations are related to our model. The ETF has a USD mandate, so we backed out FX-based returns. The Rolldown return is typically forecasted by measuring the difference between a bond’s current and forward yields. However, we couldn’t find concrete weighted average price data on the ETF. As such, we decided to use its historical price returns (since inception). This method is merely a substitute for a metric that would’ve been more theoretically correct. Our all-in forecasted return is lower than the ETF price return during the past year, likely due to the effect of coupons and our higher credit and low yield estimates. Realized Returns (iShares) Worst Case Scenario You might’ve realized that I didn’t include a worst-case scenario in the previous section and instead used a “worse-case” scenario. Instead, we decided to convey FALN ETF’s worst case via a regression analysis. Portfolio Visualizer The regression illustrates the following. FALN ETF’s maximum drawdown (from its peak) is 17.82%, which shows it is susceptible to extended losses. FALN ETF has a negative skewness figure of 1.82, suggesting it has more negative outliers than positive outliers. FALN ETF has a monthly conditional VaR (5%) of 7.17%, meaning its unexpected losses reach an average of 7.17% in 5% of its traded months. The aforementioned risk factors show that FALN ETF can be susceptible to tail risk. Thus, investors should be prepared for occasional losses. Expanding On FALN ETF’s Dividends FALN ETF has a trailing dividend yield of 5.91% and an average yield of 5.59%, which we find commendable. However, it still falls below those of some of its peers, like HYXF ETF (HYXF), HYLB ETF (HYLB), HYLS ETF (HYLS), and HYDB ETF (HYDB). Peer Analysis (Seeking Alpha) Despite having a yield lower than some of its peers, an isolated view suggests that FALN ETF has consistent dividend payouts, which we expect to continue due to the previously illustrated tradeoff between par yields and credit spreads. Seeking Alpha Expenses FALN ETF’s expense ratio of 0.25% is lower than most of its peers. Given the size of the fund’s AUM, which could easily lead to higher turnover costs, we find this compelling. Moreover, considering the ETF’s return potential, we think the expense ratio is lucrative. Seeking Alpha Limitations of The Research The article outlined numerous risks related to FALN ETF. However, we failed to mention the study’s limitations. Let’s run through a few of them. Firstly, we made numerous hardline assumptions, including the pending trajectory of the yield curve and credit spreads. The bond market is highly variable; therefore, such assumptions should be considered cautiously. Furthermore, we discussed a few of FALN ETF’s issuers. However, we didn’t delve into each issuer’s tranching structure, which is often more important than assessing the issuing entity. Lastly, as mentioned before, our factor pricing model assumed a rolldown return equal to FALN ETF’s past price returns instead of using the correct methodology. Final Verdict We believe the iShares Fallen Angels USD Bond ETF is well-placed as our key measures suggest its all-in returns are aligned with key risk premiums. Moreover, the ETF’s impressive dividend yield portrays the possibility that its credit risk attributes contribute to its dividends. Furthermore, our pricing models convey lucrative return potential despite FALN ETF’s embedded risks. We think the ETF’s return potential could coalesce with its best-in-class expense ratio to deliver shareholders excess value. Consensus: Buy

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