The Rising Risk of Fallen Angels: Credit Deterioration in the US Investment-Grade Bond Market

The U.S. investment-grade bond market is facing a growing threat from "fallen angels"-corporate bonds downgraded from investment-grade to high-yield status. In 2025, this phenomenon has accelerated, with approximately $50 billion in corporate debt crossing the threshold into junk territory, driven by a confluence of economic pressures, rising interest costs, and structural vulnerabilities in the BBB-rated universe according to Insight Investment. For institutional investors, this trend demands a reevaluation of credit risk management frameworks and portfolio rebalancing strategies to navigate the heightened risks and opportunities.

The Drivers of Credit Deterioration

The surge in fallen angels reflects broader macroeconomic challenges. Moderating economic growth, a slower labor market, and the Federal Reserve's balance sheet reduction have increased borrowing costs for corporations, particularly those with weak earnings and high leverage as Insight Investment reports. Sectors such as automotive, chemicals, utilities, and media have been disproportionately affected. For example, Whirlpool and Huntsman International were downgraded due to governance concerns and elevated debt levels, while WarnerMedia Holdings faced similar pressures from structural industry shifts according to Vaneck.

The BBB-rated segment, which constitutes a significant portion of the investment-grade universe, is especially vulnerable. These issuers often operate near the cusp of high-yield status, making them susceptible to downgrades during periods of economic stress. Historical data shows BBB-rated bonds have averaged a 13% loss in the three months prior to a downgrade, with losses spiking to 24% during downturns.

Strategic Credit Risk Management

Investors must adopt proactive strategies to mitigate the risks posed by fallen angels. One approach is to extend the holding period for downgraded bonds. Research indicates that allowing fallen angels to remain in investment-grade indices for 12 months post-downgrade can yield an average 18 basis point improvement in excess returns compared to rigid sell-on-downgrade policies. This strategy leverages the historical tendency of these bonds to rebound after initial price dislocations caused by forced selling from passive funds.

Quantitative models also play a critical role. Completion portfolios, which align multi-manager strategies with target risk exposures, help institutional investors manage unintended sector or regional imbalances while maintaining diversification. Additionally, credit portfolio trading-leveraging liquid alternatives and ETF-based strategies- reduces transaction costs and enhances access to hard-to-trade fallen angels. For instance, in Q3 2025, fallen angels outperformed the broader high-yield market by 0.59%, driven by spread tightening and favorable security selection.

Portfolio Rebalancing in a Shifting Landscape

The rise of fallen angels necessitates a recalibration of portfolio rebalancing techniques. Traditional calendar-driven rebalancing, which often triggers predictable market impacts, may no longer suffice in a volatile credit environment. Instead, systematic approaches that incorporate macroeconomic signals and sector-specific risks are gaining traction. For example, the Energy sector contributed significantly to fallen angel performance in 2025 due to tightened spreads, while the Media sector lagged.

Institutional investors are also diversifying into alternative assets to offset credit risks. As noted in the 2025 Fall Investment Directions report, allocations to commodities and liquid alternatives can improve risk-adjusted returns amid geopolitical uncertainties and fiscal risks. This diversification is particularly relevant for portfolios exposed to sectors like Basic Industry, where Huntsman International's downgrade amplified sector-specific risks.

The Opportunity in Caution

While the risks of fallen angels are undeniable, the current environment offers unique opportunities. The default rate remains historically low, and the migration of high-quality fallen angels into the high-yield market has improved its risk-return profile. Investors with the capacity to hold these bonds through short-term volatility-such as those employing active management or completion portfolios- can capitalize on valuation recoveries.

However, success hinges on disciplined credit selection and structural awareness. As Russell Investments emphasizes, quantitative models must account for sector imbalances and factor exposures to avoid unintended risks. For example, the Real Estate sector's strong performance in early 2025 highlights the importance of sector-specific analysis in rebalancing decisions.

Conclusion

The rising prevalence of fallen angels in the U.S. investment-grade bond market underscores the need for robust credit risk management and adaptive portfolio strategies. While economic pressures and sector vulnerabilities persist, a combination of active management, quantitative tools, and strategic diversification can help investors navigate this evolving landscape. As the market continues to grapple with the interplay of macroeconomic forces and corporate credit dynamics, the ability to balance caution with opportunity will define successful outcomes in 2025 and beyond.