Negative Convexity and Value
By: Heather Rupp, CFA, Director of Research for Peritus Asset Management, the sub-advisor to the AdvisorShares Peritus High Yield ETF (HYLD)
All investors need to focus on the expected return of an investment. Price movement is certainly a piece of this, but history has indicated that much of those long term returns in fixed income and equity investing have come from yield. In bond investing, an incredible amount of information on yield is published by various funds and managers and can be confusing to many investors. However, we view the yield-to-worst (meaning the yield to the worst return outcome, outside of a default, in holding a bond, which is generally the first call or maturity) as a good proxy to assess the potential return. In the high yield bond market, it is amazing to see how many investors and advisors continue to purchase the passive/index funds without any consideration of this metric. So much emphasis is placed on fees and trading volume that they have forgotten what it is these funds own and ignore the starting yield they provide.
In analyzing the yield-to-worst, corporate bond investors must deal with the “callability” of their bonds. This means that after a certain period of years following issuance (typically three or four years) the bonds can be called by the company. They are generally called because the company can refinance them cheaper and/or the company feels there is an opportunity to extend the maturities. While investors usually receive a call premium (we typically see this premium start at $104 or $105, then declining to $100 as you get closer to maturity), they also lose the bonds and must redeploy the proceeds, often in a lower rate environment. What we have seen over the past couple years is that many bond prices have traded to premiums well above their call prices (known as negative convexity), meaning investors will suffer principal losses upon a call or maturity.
We see this as a major problem for passive/index funds. If we were to look at the largest passive, index-based high yield exchange traded fund, iShares iBoxx $ High Yield Corporate Bond ETF (ticker HYG), just how much of this portfolio trades for a price above the typical first call we see of $105? Even with the massive refinancing effort over the past few years, nearly 64% of the HYG portfolio trades at or above $105, which represents $8.5 billion in assets! In fact, the average dollar price of this $8.5 billion is $109.77. More specifically, over 44% of the portfolio trade at prices above the company’s call price.1 So investors buying this fund today are paying a massive premium for over half of the fund. Because these funds have no mandate or impetus to sell and capture these premiums by the nature of their passive structures, investors today are building in future principal losses. If we do ultimately see a slowing of refinancings, then eventually that principal loss could be amplified as you get closer to that par maturity price.
We see this issue as pervasive with passive, index-based investing. A notable portion of the high yield market, thus the indexes and the products that track them, has appreciated to huge premiums above call prices, not only leading the potential principal losses, but also a very thin yield-to-worst on much of the market. There are a few things to keep in mind as we ponder this issue. First, we should note that the 30-day SEC yield reported by various funds is not necessarily a good barometer of prospective return as it does not fully reflect this issue, as this yield metric factors in income less costs over the prior 30 days and period-end price, so it is more reflective of a current yield than a true yield to worst. Yet, the reported yield to worst levels on the index, currently at a near record low level of 5.2%, does reflect this issue.2
These near record low yields lead many to naturally ask the question, is there still value to be had in high yield investing? Well, we see the answer as yes and no. For the indexes and passive products, as noted above, this negative convexity is a pervasive issue and will likely lead to principal losses for certain securities. And in many cases we don’t see the yield as sufficient for the risk being assume, yet these funds have no ability, based on the fund mandate, to sell these securities. So in today’s market, we don’t see attractive value in the passive, index-based products.
Yet for active, unconstrained investors, we certainly see a different situation. Active managers can capitalize on these premiums by selling these over-valued securities and locking in their gains, and redeploy proceeds into better yielding securities. There are still plenty of bonds and loans in the market offered by sound companies, as well as some dividend paying equities, at what we see as attractive yields. We view this flexibility to participate in the entire capital structure of a company as an important benefit in this environment. Able active managers can weed out the selective opportunities from the over-valued, low yielding securities. Investing still involves buying low and selling high. To buy and hold forever is not a strategy. It works when money is rapidly flowing into the asset class, but that pace has slowed and now investors must factor in call prices and potential principal losses. Now it is time for active management and unconstrained investing.
1 Data sourced from Bloomberg, based on holdings of iShares iBoxx $ High Yield Corporate Bond ETF as of April 25, 2014. Holdings, prices, and other statistics subject to change.
2 The yield on the Bank of America Merrill Lynch High Yield Index as of 5/1/14. The Bank of America Merrill Lynch High Yield Index monitors the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market. Index data sourced from Bloomberg.