Given some of the events in 2020, what has struck you as unique within the high yield ETF or high yield space so far?
One observation about the high yield market is the amount of issuance year-to-date. There’s a unique combination of both stress in the market and new issuance which are at odds with each other. We typically don’t see credit creation when the market is priced for increasing defaults. Maybe the market is normalizing after shrinking in three of the last four years: in 2020, the Bloomberg Barclays U.S. High Yield Index market value has grown over 8%. We saw robust issuance to start the year in January and February as issuers tapped the market to take advantage of declining rates and stable credit spreads. Then March was flush with fallen angels, contributing net new debt to the high yield market and June just set a record for single month issuance as companies built war chests to weather the pandemic. The COVID-19 market impact was sheer panic in March, and the price moves that we saw on the way down were unprecedented. Given the Federal Reserve’s (Fed’s) liquidity actions, we saw similar unprecedented price moves up. The price volatility has added a layer of complexity, especially taking the liquidity challenges in the secondary market and excess primary supply previously mentioned.
Another observation is that multiple index providers postponed their March rebalance due to the volatility. It’s interesting because it really changes the narrative that an index is a benchmark for investors. Intentional or not, index providers showed their concern regarding the investability of their index over a systematic application of the index rules.
Why should clients think about investing in high yield at these levels, given the run-up?
When we look at the credit cycle, high yield usually sells-off pretty dramatically and then grinds back over time in a more linear fashion. Right now, with option-adjusted spreads (OAS) around 550-600 basis points, we are slightly wide to the 10-year cycle average of 490 bps. This may not be the cheapest entry point, but from the same perspective, you have economic stimulus coming from the legislative side and the Fed supporting liquidity so there is an implied floor in the market. It seems that there are a lot of exogenous factors supporting high yield at these levels with an expectation that they will normalize at some point in more sanguine times but we all remember how the Taper Tantrum and the US ratings downgrade created pockets of volatility so we’ll see.
The forecasts for fallen angels in 2020 are at multiyear highs. When a company is downgraded from investment grade to high yield, how do you manage that process?
Our fallen angel approach is very similar to what we do in the primary market as we assess the index compositional impact and analyze liquidity and relative valuations. Our internal liquidity analytics determine an appropriate glide path for sourcing these positions so we can optimally track the index. We have scale products in both the investment grade and high yield asset classes, which allows us to have an open dialogue with our investment grade portfolio managers and traders to manage the transition as well. We identify the optimal bonds for sampling purposes and construct trading strategies based on the technical trends.
We are also aware of the empirical evidence around fallen angel performance and the opportunity for excess returns over the subsequent 12-24 months from the date of downgrade. The investment grade universe is multiples larger in both size and investors than the high yield universe so as fallen angels transfer to a smaller market, you tend to see a price discount associated with fallen angel bonds to incentivize high yield managers to sell their existing positions and buy these new entrants. We try to maximize this premium as bonds cross the different investor bases as well.
How does an index manage a default, and as an ETF manager, do you participate in the bankruptcy and reorganization process?
Restructurings consume a lot of our time and managing the various default scenarios is a core competency that we have developed managing high yield beta portfolios for over 15 years. There are two kinds of defaults from an index perspective. Selective Default occurs during a distressed exchange that typically includes principal forgiveness on legacy bonds in exchange for new bonds that may be structurally senior or have a higher coupon. The ratings agencies determine the debt impaired due to the issuer’s inability to fully repay the debt at par. Payment Default happens when the company skips a scheduled interest or principal payment. Issuers typically have a 30-day grace period prior to entering bankruptcy protection. In a time of broad market stress like this, certain issuers will skip payments to increase their negotiating leverage with other creditors. Then they will cure payments – meaning they go back and make a payment – and the bonds are no longer in default and reenter the index. Distressed exchanges are typically shorter and not necessarily absolute when compared to a bankruptcy court restructuring.
In terms of the bankruptcy and reorganization process, we participate in the restructuring process, especially when we believe there will be index eligible bonds post restructuring. I would estimate that more than 50% of “defaulted” bonds reenter the index either as new debt post-bankruptcy (as a condition to exiting bankruptcy) or through the exchange of existing debt, which may consolidate several tranches into index-eligible bonds.
How do you manage the illiquid parts of the indices that you track relative to replication versus liquidity?
Given the turnover in JNK, we’re hyper-focused on liquid bonds to support the premium stability from a total cost of ownership perspective for our clients. We segment the market by liquidity characteristics and quantify the trade-off between price and timing when trading illiquid bonds. We don’t want to superficially move prices due to our flows so we want to be price disciplined. We manage these trade orders and position exposures off of our trading desk, because we have a very talented trading team and they have been effective at sourcing illiquid bonds within a market price context.
We will also look at proxy positions based on market segmentation but remain disciplined on our cost-per-exposure framework. We won't force price to replicate the index and we will look for complementary positions or proxy positions to seek the exposure in a more cost effective way.
How should investors think about the three high yield exposures SPDR offers?
I think what is most attractive with JNK (SPDR Bloomberg Barclays High Yield Bond ETF) is really the liquidity surrounding the product and the amount of daily volume. When I think of the high yield beta products out there, the total cost of ownership for JNK is extremely competitive. In fact, I view it as potentially favorably as far as average premium and premium volatility relative to other products.
SJNK (SPDR Bloomberg Barclays Short Term High Yield Bond ETF) is a potential attractive part of the market, as it includes bonds with a maturity of 0-5 years. Short-duration high yield has interesting constituents of higher quality, non-callable bonds combined with short maturity special situations, in which case, investors can take a barbell approach across the quality spectrum while limiting interest rate exposure.
SPHY (SPDR Portfolio High Yield Bond ETF) changed its benchmark in April 2019 to track a broad HY index from ICE BofA. Sourcing smaller, less liquid bonds can be prohibitively expensive, especially for short-term tactical investors. SPHY’s broad portfolio holdings include bonds considered off-the-run and with smaller issuer sizes, yet these securities historically have offered incremental yield over the larger liquid bonds. Buy-and-hold investors may benefit from owning SPHY’s broad portfolio, while short-term tactical investors would prefer JNK’s liquidity profile.
Can you comment on the overall high yield franchise at State Street Global Advisors?
Our ETF products comprise approximately 60% of our AUM. We have scale and a long track-record managing high yield beta portfolios across the spectrum from broad market to very liquid to short duration to up-in-quality BB/B. Our products include commingled funds, ERISA funds and separately managed accounts and we have custom mandates as well.
ETFs give us great insight into the market liquidity because they are very effective and widely used beta products. When I think of different investor types within JNK, such as global macro funds trading relative value or momentum funds trading based on price technicals or even more permanent capital looking for the most liquid product on the institutional side, having a broad set of clients and products provides us with a holistic view of the market and market participants.