So much has been made of indexing/passive-investing over the past several years. Investors are often enticed by the lower fees and broad exposure, and often the perception that there is lower risk via the thought it that you won’t underperform the index. But in fact, many passive products do underperform their benchmark and we believe the restrictions put in place with tracking an underlying index, or sub-index in many cases, can put passive funds at a disadvantage.
It can be hard to replicate an index, especially in the high yield bond market. Once issued, high yield bonds have an active and liquid secondary market, much like stocks. However the difference is that bonds don’t trade on an “exchange” like stocks do. Instead, bonds trade over the counter, in negotiated transactions among buyers and sellers. Trading relationships are important for sourcing secondary bonds as well as getting allocations for newly issued deals. Be it supposed ease in sourcing product or the perception that size equates to liquidity, some of the larger passive funds, such as the two largest in the high yield ETF world, focus only on larger issues, as we discuss below.
But just what does a broad high yield bond index look like? Two of the more widely followed high yield bond indexes are the BofA Merrill Lynch High Yield Index and the Bloomberg Barclays High Yield Index. The BofA Merrill Lynch US High Yield index includes 1,877 issues with a market value of $1.3 trillion. The index currently carries a yield to worst of 5.61%, yield to maturity of 6.10%, average coupon of 6.44%, duration of 3.64yrs, and average price of $101.36.1 The Bloomberg Barclays US High Yield Index, which includes 2,024 issue and $1.3 trillion in market value, carries a yield to worst of 5.61%, yield to maturity of 6.09%, average coupon of 6.44%, duration of 3.84yrs, and average price of $101.43.2 It is important to understand what is in an index and how that is reflected in these average statistics. For instance, yield is a key statistic that investors pay attention to, and as we look at the BofA High Yield Index, 27% of the issues trade at a yield to worst of under 4% and over half of the issues trade at a yield to worst under 5%.3
Again, as we look at some of the larger index-based vehicles, they cover a subset of the broader index. For instance, the two largest high yield bond ETFs track sub-indices that have minimum tranche size constraints, (i.e., $500mm for one and $400mm per tranche/$1bn in total debt for another). These sub-indices have 700-1,000 issues, so about half or less of the total number of issues in the broad high yield index. We believe these size constraints put investors at a disadvantage as it is often in the issues/tranches that do not meet these size minimums that we have historically seen the most value.
Understanding an index and vehicles that track them helps us understand where active managers may have the ability to create value for their investors. The most basic mandate of a passive, index-based vehicle it to track the underlying index or sub-index. Be it size constraints or having to largely include what is in the underlying index without focus on the yield generated or the credit’s prospects, we believe arbitrary restrictions put investors at a disadvantage. Rather our goal as an active manager is to generate a higher yield and higher total return than the high yield indexes and passive products.
We work to achieve this by being selective as to the securities that we own and focusing on where we see value in the market. For instance, we aren’t forced to fill half of our portfolio with very low yielding securities, or buy the credits where we see clear credit and/or default risk. We are able to focus our strategy on higher yielding securities where we see value. It should be noted that we don’t believe we are getting aggressive in terms of credit quality (or lack thereof) in stretching to garner yield. Because we do not set limits on the size of an issue as many of our competitors do, we are able to find plenty of value in off the run names. In addition, we are able to look for discounts to par or to call prices, which we believes gives us the ability to generate some potential capital appreciation. Furthermore, we have the flexibility to allocate a portion of our strategy to floating rate loans, which serves to expand our investment universe as we look for that value.
As an active manager, we are selective as to what securities we own and focus on where we see value relative to the risk in the market, as we work to generate consistent tangible income and potential alpha for investors.