Bond Exchange Traded Funds
1. Limited supply of issues could impact holdings. Weakening credits are usually easier to buy.
2. In a slowing economy investment grade downgrades usually increase and percentage of “distressed” credit ratings in High Yield index increase.
3. Index may have unwanted exposure – Energy in 2015; Autos in 2007; Telecom in 1999.
4. In 1989 and 1990 the Barclays High Yield Index principal value fell about 25%; it fell 10% in 2015.
5. Market makers may bid for ETF shares well below NAV and offer well above NAV.
Investing in a passive benchmark as an alternative to active management could be more risky. Unlike the equity indexes, such as the S&P 500, where all securities are readily available for purchase and sale, this does not hold true for the corporate and high yield bond markets. First, they are huge: the Barclay’s Corporate Index is comprised of 5,680 issues totaling $4.4 trillion (12/31/15), while the High Yield Index is comprised of 2,174 issues totaling $1.2 trillion. Second, they are very broad, or fragmented, with the average issue size of Investment Grade Corporate Bonds at $757 million and the average issue size of High Yield Bonds at $619 million. This “float” per issue is miniscule compared to that of S&P 500 stocks. So, replicating the index is problematic because there is a very limited supply of the represented securities (prompting high tracking error concerns). Rarely in life is that which is easiest to obtain also the “best.” For example, the largest issuer in the High Yield Index, and therefore easily purchased bonds, were those of Sprint, which was downgraded to high yield (CCC) from investment grade in September 2015. Caesars was also one of the largest issuers of high yield debt and that company is now in bankruptcy. In all, there were approximately 50 downgrades by Moody’s from Investment Grade to “junk” status from 2013 through 2015. Many investors cannot own CCC rated debt (or have concentration limits in that and lower rated categories); this can result in significant forced selling, further impacting the market price of the security. So, the “automatic” nature of index investing tends to preclude the conscious decision to exclude bonds due to future quality concerns.
Another important issue for most indexes is that they are market capitalization weighted. This fosters the concept of the “bums” problem. That is, the biggest issuers (and industry groups) are larger components of the index. In 2014, Sprint and Caesars were 2 of the largest issuers in the composition of the Barclays Corporate Bond Index. After downgrades removed them from the index, index funds would be forced to sell “automatically.”
Back in mid-2013, the Energy Sector comprised approximately 10% of the High Yield Index and grew to 16% by mid-2014, only to shrink back to 10% in early 2016 as the result of bankruptcies and significant price deterioration. An ETF replicating the Index would have been subject to the deterioration represented by this Sector.
Another consideration is the increase in credit downgrades when the credit cycle begins to deteriorate. As the number of lower quality issues grows and lower ratings become a larger portion of the index, the ETF increases its exposure to weaker credits. Barclay’s Corporate Index moved from 32% in 2006 to over 50% in BBB rated credits today (5/31/16) as the 2007-2008 financial crisis and the more recent decline in energy prices negatively impacted credit quality. Further adding to this increase has been large M&A transactions funded, in many cases, through the issuance of BBB rated debt. Isn’t an index changing exposure at the wrong times? The High Yield Index shows similar behavior. Currently (5/31/16) CCC and lower rated bonds represent 16% of the index. Full cycle total return performance has been poor relative to the BB and B rated “upper tier.”
So not only has the investment grade universe experienced credit deterioration over time, but the High-Yield market is quite different due to its exposure to credit and industry cycles. Companies come and go, and industry sectors more quickly grow and shrink over several years. We feel this dynamic favors active management for more conservative investors.
This information is intended solely to report on investment strategies identified by Cincinnati Asset Management. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument.