It is interesting how effective sarcasm can be. I will never forget the first time I read a critique of an economic prognosticator who had “predicted ten of the most recent three recessions!” That style of critique avoids the tasteless use of name-calling or character assassination – and yet quite effectively makes its point.
That is how I have felt during the past couple of years regarding the chronic, and invariably confident, assertions within the popular business press that the “bond bull market” is dead and those holding bonds (especially U.S. Treasury Bonds) will pay a steep price as rates inexorably and invariably rise from historic lows.
The most memorable (and infamous) of those predictions came early in 2011 from noted “Bond King” Bill Gross – who was certain U.S. Treasury Bonds had reached their apex were bound to fall in price. He positioned the world’s biggest mutual fund (Pimco Total Return Fund (PTTRX)) accordingly and suffered significant underperformance during the months that followed. There is absolutely no other fund manager for whom I have as much respect as Bill Gross (I cut my teeth on bonds by listening to him wax eloquent about bonds on the old Wall Street Week With Lou Rukeyser TV show – yes, that dates me) and adding to Bill Gross’ long list of character strengths is the fact that he later admitted that he had made an error!!
However, countless other lesser known prognosticators have been predicting “an ugly end” for bondholders for years now. The truth is that, until 2013, every last one of those so-called “experts” has been wrong! Meanwhile, perpetual bond bulls (such as Gary Schilling, who has been bullish on bonds for decades) have been enjoying risk-adjusted returns far superior to buy and hold equity bulls).
No one knows with certainty what the remaining 7 months of 2013 will bring (although Bill Gross very recently proclaimed “an end” to the bond bull market). However, every single week this year, I have read at least one dire warning to holders of high yield bonds that (to paraphrase) “Armageddon is approaching; you’ll be sorry if you keep holding them!” Earlier this year, high yield bond prices dipped, and those high-yield “bears” were licking their chops – dying to tell the rest of us “I told you so!”
What happened? You guessed it – high yield rates continued moving downward, moving prices upward. By the beginning of May, the Merrill Lynch High Yield Master Index rate had reached a record low of 5.24%. Why is that significant (you ask)? A scant five years ago, the benchmark 10-year U.S. Treasury Bond was yielding more than the 5.24% paid now to high yield holders! The naysayers therefore point out that the return now offered to “risk takers” is not nearly enough.
Graph: The graph above shows the rates on the benchmark ten-year U.S. Treasury Bond between 2001 and 2008. Note the months in 2001 and 2002 (and almost in 2006) when these bonds paid more in interest than current high yield bond holders (on average) received earlier this year.
Someone out there in “reader land” is now thinking: “OK, Petty, enough already! Let’s get to the point!”
To which I reply: “Thank you! I needed that!”
Let’s talk U.S. High Yield Bond ETFs. The popular press (seemingly) knows of only two such ETFs: iShares iBoxx $ High Yield Corporate Bond Fund (HYG) and SPDR Barclays High Yield Bond ETF (JNK). According to YahooFinance.com, HYG has almost $16 billion in assets and a 6.51% yield; while JNK has just over $12 billion in assets and a 6.64% yield. During 2012, HYG returned 11.18% and JNK appreciated 11.79%; three year performance averages stand at 11.18% and 10.03%, respectively. The relative expense ratios for these two ETFs are 0.5% and 0.4%. In a market characterized most starkly by the FED’s “zero interest rate policy” (ZIRP) – those numbers don’t sound bad, do they?!
The chief factor these two funds have in common (besides large size) is that they are “index” funds. Their investment mandate is to mimic the composition and performance of a domestic high yield index: the Markit iBoxx USD Liquid High Yield Index (HYG) or the Barclays High Yield Very Liquid Index (JNK). The bottom line in each instance is that they end up buying what the “indexer” determines to fit best within the prescribed index – and the funds tend to end up (largely) with a mix of large company high yield bonds, frequently straight from an IPO issue. This means that the funds (for the most part) do not weed out the weaker issuers. The danger this poses is that (naturally) in this record low-interest environment, many lower-rated companies have jumped on the opportunity to issue high yield debt in order to secure “cheaper” financing. So many relatively undesirable company issuers are represented in each fund.
Into that setting jumped the folks from AdvisorShares, who recognized an opportunity to create an “actively-managed” fund in the domestic high yield area: Peritus High Yield ETF (HYLD). Here is a graph contrasting the relative performance of HYLD with HYG and JNK over the (essential) life of HYLD (December 2010 through the present). The solid blue area is HYLD; the red line is HYG and the green line is JNK. Obviously, both index funds had an extremely rough first half of 2011, but made an impressive recovery by year-end.
Demonstrating the importance of reviewing multiple time frames, here is a picture of relative performance during the most recent twelve-month period. It lends the viewer a different impression, doesn’t it?
Moving on to review even more recent performance, below is a graph of the relative price movement among these three ETFs “year to date” (YTD). Note that in this view, HYLD once again appears to be a better relative performer. Even the steep decline during this past week that impacted all three funds seems to have caused a slightly gentler downward slope in HYLD than in HYG or JNK.
Then finally, here is a 3-month view of the ETFs. The impact on high yield bonds that resulted from the “mixed message” from the FED on May 22nd is dramatically more evident in this graph than in the other graphs. You may or may not agree that that drop “into a pit” that inflicted all three ETFs was slightly gentler for HYLD than the others… but when one is descending into the lower depths, I guess it doesn’t make much difference how fast you are descending! The direction and speed are most definitely flat out “ugly” looking!
What can one make of all of this? First, it is important to note that, at least until recently, HYLD has been operating with limited visibility. In sharp contrast to the size of the other two funds, HYLD currently (as of May 30) reports just $275 million in assets.
However, there is reason to believe that market perception may be shifting in HYLD’s favor. As of mid-April of this year, HYLD boasted just $210.8 million in assets and averaged daily volume that didn’t even get to 40,000 shares. Meanwhile, HYG has lost more than $740 million in assets (three times the size of HYLD’s asset base) during May and JNK has lost more than $765 million in assets! Between April and May, HYLD’s assets increased by about 30% while its daily volume doubled to over 81,000 shares per day!
Other data points for HYLD include the following: a twelve month yield of 8.03%; a one year total return of 12.08%; and a one year expense ratio of 1.35%. You should be thinking: “Wow, that is a sky high expense ratio!” You would be correct. However, HYLD’s higher yield and overall performance is calculated after being adjusted for expenses.
What can account for HYLD’s performance edge? As hinted earlier, it is the result of being actively-managed (very much tied to the higher expenses). The AdvisorShares’ website explains their approach this way: “Peritus takes a value-based, active credit approach to the markets, largely foregoing new issue participation, favoring instead the secondary market where Peritus believes there is less competition and more opportunities for capital gains. Peritus de-emphasizes relative value in favor of long-term, absolute returns.” Finally, one additional key dimension of active management is reflected in the respective “duration” metrics for the three ETFs (“duration” measures the sensitivity of a bond or fund to changes in interest rates): 2.96 years for HYLD; just under 4 years for HYG; almost 4.3 years for JNK. This means that HYG and JNK are significantly more vulnerable to rising interest rates than HYLD.
Two final notes: First, I am neither endorsing nor recommending HYLD, HYG, or JNK as an investment. If you consider any of them, please consult your financial advisor before acting. Second, anyone who is determined to garner higher earned interest than available through risk-free T-bills or CDs could consider other forms of higher yield investment vehicles, including low duration high yield bonds, senior bank loans, short-term investment grade corporate bonds, etc. (we will cover several of these very soon).
Disclosure: The author has owned HYLD for months.
Submitted by Thomas Petty
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