Look for “Rising Star” bonds in a rising rate environment. Here are 3 ETFs to consider.

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Bond strategist Peter Tchir likes fallen angel bonds for their near-term upside potential.

Christopher Goodney/Bloomberg

The short-term outlook for corporate bonds is bleak, as the Federal Reserve is expected to raise rates multiple times this year, but there may be some “rising stars” to bet on.

Most corporate bonds have fixed interest rates, so their prices fall when yields rise. Fed rate hikes are expected to drive up corporate bond yields and lead to losses.

But there are still corners of the market where investors can try to capture yield and capital appreciation as the Fed prepares to tighten policy, Peter Tchir of Academy Securities said Tuesday. It favors the higher quality level of the junk bond markets, bonds rated one to three levels below investment grade (BB+, BB and BB-).

He recommends this group because it includes many of the likely candidates for “rising star” upgrades, or bonds that are upgraded to investment status. When bonds exit the junk market and achieve investment grade ratings, they can offer capital appreciation on top of their yield. In their outlook for the coming year,


German Bank

strategists predict there could be $40 billion in rising stars this year, and


Bank of America

strategists predicted $90 billion.

To find these rising stars, Tchir wrote, investors can look at bonds from “fallen angels” or companies that were originally investment grade but later downgraded to junk. Many of these bonds eventually reclassify to higher quality markets after their issuers strengthen their balance sheets.

Some options are


iShares Fallen Angels USD Bond ETF

(symbol: FALN) and the


VanEck Fallen Angel High Yield Bond ETF

(ENG). Both track fallen angel bond indices, and the VanEck fund is slightly more concentrated – with 250 holdings versus 350 for the iShares fund – and slightly more expensive, with its expense ratio at 0.35% versus 0. 25%.


Citigroup

High-yield strategists also recommend fallen angel bonds, as they “expect many of the [bonds] will return to [the] Investment Grade universe in 12 to 18 months. In a Feb. 2 note, the bank’s high-yield strategists found that fallen angel bonds have outperformed the rest of the junk bond market by an average of 3 percentage points per year over the past two decades.

There is however a catch. Rising interest rates tend to further dampen the performance of fallen angels, as these bonds tend to have longer maturities and greater interest rate sensitivity. (Investors generally don’t want to lend to low-rated companies for long periods of time, but higher-rated companies can often persuade investors to lock in their money for decades.)

This sensitivity to U.S. interest rates not only darkens the outlook for fallen angel bonds this year, but also explains some of the historic outperformance identified by Citigroup. Benchmark treasury yields have fallen over the past two decades as a rule, meaning long-term, high-quality bonds have outperformed most other segments of the bond market.

Still, US interest rates and the Fed’s key rate are expected to rise this year, and long-term bond yields have jumped, with the benchmark 10-year Treasury yield climbing to 1.95% from 1.52% so far in 2022. This has resulted in losses. in fixed-rate bond markets across the board, and fallen angel ETFs are no different. The iSharesFallen Angels fund is down 4.5% so far this year, and ETF VanEck is down 5%.

So investors who are able or willing to buy individual bonds should focus on debt maturing in 3 to 8 years, Tchir wrote. He also recommends the


SPDR Bloomberg Short Term High Yield Bond ETF

(SJNK), a fund that holds short-dated junk bonds.

Compared to the two Fallen Angel ETFs, this ETF is less likely to hold large holdings of “rising stars” – it only holds 45% BB-rated bonds, compared to nearly 90% in the other two. But it has outperformed fallen angel funds, losing just 1.7% so far this year. Incidentally, all three ETFs have beaten the S&P 500’s 5.8% loss year-to-date.

To offset the risk of rising bond yields, Tchir also said he would consider shorting “small amounts” of the iShares iBoxx USD Investment Grade Corporate Bond (LQD) ETF, which tracks a wide swath of the market for investment grade bonds.

Another popular game for rising rates is floating rate debt. But Tchir is wary of this market, as it has remained strong as fixed-rate bonds have sold off. And if the year-to-date sell-off in risky markets continues to gather pace, he says the losses could eventually trickle down to floating-rate debt.

In short, bond market investors don’t have many good places to find value as yields rise. So they may have to get creative and try to find rising stars for comebacks.

Write to Alexandra Scaggs at [email protected]

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