What is FALN? (Pros, Cons, and Strategies)

If you're looking to diversify your fixed-income portfolio with a focus on attractive yields, the iShares Fallen Angels USD Bond ETF (FALN) might be worth considering. This ETF offers a unique approach to bond investing, focusing on “fallen angels,” which are bonds that were initially rated as investment-grade but have since been downgraded to junk status. Today, we will explore what FALN is, along with its advantages and disadvantages.

What is FALN?

FALN is an ETF designed to track the performance of the Bloomberg Barclays US High Yield Fallen Angel 3% Capped Index. This index includes bonds that were once rated as investment-grade but have subsequently been downgraded to a lower credit rating.

FALN aims to invest in these downgraded bonds, which may offer higher yields due to their lower credit ratings, while still having the potential for credit upgrades.

Key Features of FALN

• Focus on Fallen Angels: Bonds initially rated as investment-grade, now considered high-yield.
• Diversification: Exposure across various sectors, such as energy, consumer goods, and utilities.
• Capped Holdings: Limits to individual holdings to ensure diversification and manage risk.

After selecting the "fallen angels," the index then caps the exposure to any single issuer at 3% to ensure proper diversification and risk management.

FALN Composition

FALN's portfolio mainly includes bonds from sectors like energy, consumer goods, and utilities. Some examples of bonds in this ETF may include those issued by companies like Ford, Occidental Petroleum, and Kraft Heinz. The composition is designed to provide diversified exposure to various high-yielding sectors, balanced by a capped structure to reduce risk.

Pros of FALN

High-Yield Potential

Investing in fallen angels can offer high-yield potential. Since these bonds were originally investment-grade, there is a chance that they could be upgraded again, providing capital appreciation in addition to their higher yields.

Diversification Benefits

FALN provides exposure to a diversified portfolio of bonds across various sectors and issuers, which helps manage credit risk. The capping mechanism prevents overexposure to any single company, which is crucial for risk management.

Historical Outperformance

Past performance indicates that fallen angels as a category tend to outperform other high-yield bonds. This can be attributed to their potential for credit upgrades and recovery, offering both high yields and capital gains.

Lower Expense Ratio

FALN features a relatively low expense ratio for a high-yield bond ETF, generally around 0.25%. Lower expenses contribute to better net returns for long-term investors.

Cons of FALN

Credit Risk

Despite the potential for recovery, fallen angels are still considered junk bonds and come with inherent credit risk. Poor economic conditions can further deteriorate their credit standings, impacting returns negatively.

Interest Rate Sensitivity

Like other bond ETFs, FALN is sensitive to interest rate changes. Rising interest rates can decrease bond prices, impacting the overall performance of the ETF.

Volatility

With higher yields comes higher volatility. FALN can experience significant price swings, which may not be suitable for conservative investors seeking stable income.

FALN Investment Strategies

FALN's focus on fallen angels makes it a unique investment vehicle within the bond market. Its performance depends largely on the recovery of the downgraded bonds, making it more suitable for certain investment strategies.

Long-term Investment Strategy

Given the potential for bond credit upgrades and high yields, FALN can be a good fit for long-term investors who are willing to take on additional credit risk for higher returns. A holding period of 5 to 10 years or more allows investors to benefit from both high yields and potential capital appreciation if the credit ratings of the bonds improve.

Yield-focused Strategy

FALN is ideal for income-seeking investors who prioritize yield. The high current income offered by this ETF can be a significant addition to a diversified income portfolio. This makes it suitable for investors like retirees who need steady income streams.

Diversification Strategy

FALN can act as a diversification tool within a broader fixed-income portfolio. By including higher-yield bonds across various sectors, investors can mitigate risks associated with sector-specific downturns.

Conclusion

FALN offers a compelling proposition for investors seeking high yields and diversification within their bond portfolios. While it comes with inherent credit risks and volatility, its unique focus on fallen angels provides opportunities for both high income and capital appreciation. By aligning the ETF with long-term, yield-focused, or diversification strategies, investors can effectively incorporate FALN into their investment portfolios. As always, careful consideration of one's risk tolerance and investment horizon is crucial in making informed investment decisions.