Negative Convexity and Yield
Heather Rupp, CFA, Director of Research for Peritus Asset Management, the sub-advisory firm of the AdvisorShares Peritus High Yield ETF (HYLD), discusses how investors may not realize they are buying into future principal losses.
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 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 funds. If we were to look at the largest passive 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, over 50% of the HYG portfolio of issuers trades at or above $105, which represents $9.2 billion in assets! In fact, the average dollar price of this $9.2 billion is $110.1 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 rates rise and 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 investing. A large 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, which ultimately doesn’t bode well for the return prospects. We should note that the 30-day SEC yield 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.
Let us be clear, despite these premiums and low yields on some securities, this certainly does not mean that there is not opportunity for solid returns to still be had within the high yield market. Rather, it means that active management is all the more essential in today’s environment. Active managers can capitalize on these premiums by selling these 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 at what we see as attractive yields. Able active managers can weed out the selective opportunities from the over-valued, low yielding credits in the space. 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 in the high yield market and now it is time for active management.
1Data sourced from Bloomberg, based on holdings of iShares iBoxx $ High Yield Corporate Bond ETF as of November 29, 2013. Holdings, prices, and other statistics subject to change.