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Posted by on May 8, 2014 in Peritus Asset Management

Overview of the Fixed Income Market

Overview of the Fixed Income Market

By: Tim Gramatovich, CFA, Chief Investment Officer for Peritus Asset Management, the sub-advisor to the AdvisorShares Peritus High Yield ETF (HYLD)

 
 “Junk bonds” are often still considered an alternative asset class and remain tremendously confusing to much of the investing public.  They are considered by many to be very risky and illiquid.  The truth is that the high yield market is a relatively straightforward, well developed and liquid market.

It is important to gain an understanding of the fixed income marketplace and the investment options within it.  The first thing to note is the sheer size, which is massive (more than $40 trillion).1  Somewhat surprisingly, mortgages represent the second largest single subcategory of the bond market; this helps to explain why problems in the mortgage market nearly took down the entire financial system in 2008.  The largest subcategory is U.S. Treasury debt.

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Yet, a sizable 25% of the fixed income universe is represented by “corporate credit” through leveraged loans, high yield bonds and investment grade corporate bonds.  What comes as a surprise to many investors is that the non-investment grade sector of loans and bonds has grown to become a major asset class, now over $2.0 trillion.  We have seen record issuance in the leveraged loan and high yield market over the past couple years, making it likely this segment of the market will make up a larger percentage of the fixed income pie in the future.

By looking at the chart above it is obvious that corporate credit plays a major role in financial markets; yet, for some reason, bonds have always been considered too complex for individual investors and often remain misunderstood.  While it is true that large players, such as insurance companies, pension funds and banks, dominate the landscape, bonds at their core are simple.  A bond is a loan.  A company can issue debt (bonds) or equity (stock).  The debt/bonds rank ahead of equities in a company’s capital structure, so are considered less risky.  This ranking means that bondholders have a priority claim on the company’s cash flows and get paid first.  Corporate bonds have a maturity and an interest rate, creating a contracted stream of income for bondholders.  They typically pay this interest twice per year but trade with accrued interest, meaning that a buyer can buy the bond anytime before the paydate but would have to pay the seller the accrued interest up to that point.  The maturity is the date at which the issuer is obligated to pay the bondholder back the “par value” of the bonds.  Companies generally have the ability to refinance at some point prior to that maturity, but must typically pay the bondholder a call, or tender premium (pre-payment penalty), to do so.  This finite exit strategy, either via maturity or refinancing, is one of the great features of bonds versus equities.

Another misunderstanding investors have relating to bonds is that a bond is issued and then goes away into the hands of investors, never to trade again.  Most people do not understand that corporate bonds have an active and liquid secondary market, much like stocks.  The difference is that the “bond exchange” is not a physical location like the New York Stock Exchange.  Rather it is an electronic market created and maintained by large banks and investment banks.  These features apply to both high yield and investment grade bonds.  And a benefit of this secondary trading is that bonds can in some cases be acquired at a discount to par, allowing for potential capital appreciation in addition to the income they provide.

The high yield bond market is a large, developed, and liquid asset class.  Between the finite outcome, via the bond maturity, and the income and potential capital gains provided, we believe that this asset class should be considered as a core piece of a fixed income portfolio.  And with the advent of high yield exchange traded funds, all market participants have access to this asset class.

 

1 Blau, Jonathan, James Esposito, and Daniyal Khan.  “2014 Leveraged Finance Outlook and 2013 Annual Review,” Credit Suisse Global Leveraged Finance.  February 6, 2014, p. 133.

david@mediaworksllc.com

The AlphaBaskets blog provides frequent market insight and commentary by AdvisorShares Investments, LLC, created by AdvisorShares and other leading active managers.  AdvisorShares Investments is an SEC-registered investment adviser and the investment adviser to the AdvisorShares actively managed ETFs. The views expressed on AlphaBaskets should not be taken as investment advice or a recommendation for any of the actively managed ETFs advised by AdvisorShares.

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