Fixed Income
Fallen Angel and the Risk of Downgraded Credit
In bond markets, ratings matter. They influence yields, investor eligibility, and portfolio mandates. A fallen angel refers to a bond that was once considered safe but has lost that status.
The term sounds dramatic, but the economic logic behind it is straightforward.
What a Fallen Angel Really Is
A fallen angel is a bond that was originally issued with investment-grade status but has been downgraded to below investment grade, commonly referred to as high yield or junk.
The downgrade signals deterioration in the issuer’s credit quality. The bond itself has not changed structurally. What has changed is the market’s assessment of default risk.
Why Downgrades Matter
Many institutional investors are restricted to holding only investment-grade securities.
When a bond loses that status, these investors may be forced to sell. This selling pressure can push prices down further, sometimes beyond what fundamentals alone would justify.
Exams often test whether candidates understand this forced-selling dynamic.
Impact on Yield and Spread
A downgrade increases perceived credit risk.
As risk rises, required yield increases. Bond prices fall accordingly. Credit spreads typically widen as investors demand additional compensation for the increased default probability.
Understanding this price-yield relationship is essential for fixed income questions.
Fallen Angels vs Original High-Yield Bonds
Not all high-yield bonds are the same.
Fallen angels were once investment grade. They often have stronger balance sheets than bonds originally issued as high yield. As a result, some investors view them as opportunities if the downgrade was temporary or market-driven.
Exams may frame this as a valuation or relative value question.
Portfolio and Risk Management Implications
For portfolio managers, fallen angels create rebalancing challenges.
Mandate constraints may require sales. Risk metrics such as duration and credit exposure must be reassessed. Liquidity can also become an issue during downgrade waves.
Understanding these secondary effects is important for applied exam questions.
Common Student Mistakes
Students often:
- assume fallen angels are near default
- confuse downgrades with immediate default
- overlook institutional selling pressure
These misconceptions frequently appear in exam distractors.
Final Perspective
A fallen angel is an investment-grade bond that has been downgraded to high yield. The downgrade affects price, yield, and investor behaviour. For exam preparation, focus on how rating changes influence spreads, liquidity, and portfolio constraints. Once this connection is clear, fallen angel questions become easier to interpret.
