Why the US labor recovery supports equities and high yield credit (Part 13 of 13)
Ultra-short duration: Avoiding losses in a rising rate environment
The below graph reflects changes in popular fixed income ETFs since the 2008 crisis. As the bond market rally has softened and interest rates have risen, longer duration bonds, as reflected in the iShares Core Total U.S. Bond Market ETF (AGG), with a duration of 5.11 years, and the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), with a duration of 7.49 years, have weakened. In contrast, shorter-duration bond funds, such as the Highland/iBoxx Senior Loan ETF (SNLN) and Invesco PowerShares Senior Loan portfolio ETF (BKLN), with durations under 60 days, have maintained their price levels. Despite rising interest rate levels, the shorter duration and higher-yielding HYG and JNK continue to outperform longer-duration and higher-credit-quality AGG and LQD post-2008. Though the strength in bonds in early 2014 is contributing to a significant comeback in the longer-dated bonds, the enhanced yield of the below–investment-grade holdings in fixed income ETFs SNLN and BKLN continues to offset the duration-related gains of the longer-dated portfolios of AGG and the longest-dated LQD. As below, from 2013 to date, the high yielding ETFs reflect a 4.0% outperformance relative to AGG and LQD. This article considers the risk and reward of exposure to higher levels of credit risk versus long bond duration risk.
To gain a broader understanding of the other macroeconomic factors supporting the economic and investment-related views in this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
The sudden rise in the seven-year Treasury yields, which doubled from 1.20% in April 2013 to 2.40% in September 2013, meant that longer-dated bonds and longer-dated bond-holding ETFs, such as AGG (5.11 years) and LQD (7.49 years), incurred significant duration exposure–related losses, with the 7.49-year-duration LQD dropping 8.00% in value in seven months. While the high-quality credit in LQD may seem attractive relative to the lower-quality credit exposure in SNLN and BKLN, the above graph demonstrates the significant risk posed by long duration risk in a rising rate environment.
Credit quality risk
Plus, as the above graph illustrates, the small declines in both SNLN & BKLN, with virtually no duration exposure, can often maintain their value in a rising rate environment, as the yield premium associated with the ETF bond holdings may not always change that much in conjunction with government interest rates. However, the inverse is also possible. In a persistently soft economic environment, it’s also possible that government and other high-rated credit yields may not change that much, and that credit spreads associated with lower rated bank loans found in SNLN and BKLN could underperform as corporations see cash flow decline and their ability to service their debt is compromised.
For further analysis of this issue, please see the Market Realist analysis by Dale Norton The difference between High Yield Bond ETFs and Investment Grade Bond ETFs.
For additional longer-duration alternatives to LQD and AGG, please see Key strategy: Will deflation contain the bear market in bonds?
SNLN’s top holding: Caesar’s Entertainment—2.29% of SNLN portfolio
Caesar’s Entertainment Corporation has a fairly small market capitalization of $3.57 billion, and a CCC credit rating (below Sprint’s BB credit rating)—the highest area of the below–investment-grade category. Reducing Caesar’s $21.54 billion of debt by the firm’s $1.71 billion cash position, we’re left with approximately $23.25 billion of net debt. In contrast to Verizon’s (VZ) 9.54% profit margin and Sprint’s (S) -8.5% profit margin, Caesar’s has a negative profit margin of -19.91%. Caesar’s revenues are $8.34 billion, with an EBITDA of $1.76 billion to service its net debt of $23.25 billion, while Sprint has $5.47 billion to service debt of $25.5 billion. Meanwhile, Verizon has $48.57 of EBITDA to service its net debt of $42 billion.
These differences in debt and EBITDA earnings drive the differences in credit quality ratings from the top of investment grade, Verizon (at BBB), to Sprint (at BB) and Caesar’s (at CCC). Caesars currently has a June 1, 2017, senior secured bond yielding around 11.00%, versus Sprint’s August 15, 2007, senior unsecured bond yielding 2.95%, Verizon’s February 15, 2008, senior unsecured bond yielding 2.00%, T-Mobile USA’s February 19, 2019, senior unsecured bond yielding 3.00%, and CIT Group’s February 19, 2019, senior unsecured bond yielding 3.46% (Bloomberg & Capital IQ, December 31, 2013 Quarter).
Short duration, higher credit risk: SNLN & BKLN
If investors are concerned about a rising rate environment, they may wish to consider short-duration fixed income exposure through short-duration fixed income ETFs such as the Highland/iBoxx Senior Loan ETF (SNLN). This ETF holds senior bank loans that offer a floating rate coupon based on short-term interest rate pricing, which is typically the 90-day interbank rate, known as “three-month LIBOR” (LIBOR stands for the “London Interbank Offer Rate on Deposits,” and it’s established daily through a consortium of banks under the British Banker’s Association in London). Similarly, the Invesco PowerShares Senior Loan Portfolio ETF (BKLN) also holds senior bank loans and also has a short duration.
The duration of these “floating rate” loans is typically 40 to 60 days—much shorter duration than the typical four-year duration associated with similar corporate five-year bond portfolios. The loan portfolios also carry an additional advantage over longer-duration corporate bonds in that they have a much higher average recovery of loss rate in comparison to corporate bonds, of closer to 80% in comparison to closer to 50% in the case of similar rated bonds. It’s important to note that both of these ETFs invest in loans that are rated in the BBB to B area, and they do involve more risk of loss than portfolios rated in the AAA to A area. However, what they lack in credit rating they tend to compensate for in terms of higher returns. SNLN offers a yield-to-maturity of around 4.8% and BKLN around 4.95%.
Longer duration, lower credit risk alternatives: AGG & LQD
Should investors be wary of the credit risk, they could also consider longer-duration ETFs such as the iShares Core Total U.S. Bond Market ETF (AGG), which maintains a duration of 5.11 years, though a yield-to-maturity of 2.14%, as it holds roughly 70% of its portfolio in AAA and AA rated bonds. Similarly, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) offers a duration of 7.49 years and a 3.35 yield-to-maturity, and it holds the majority of its bonds in the A to BBB category. LQD includes higher commercial credits such as Verizon (VZ)(0.70%) and Blackrock Funds (BLK)(0.67%), whereas SNLN holds lower-rated commercial credits such as Caesar’s Entertainment (CZR)(2.35%) and Hudson’s Bay Company (HBC)(1.50%).
Browse this series on Market Realist:
- Part 1 - Why post-2008 labor market dynamics support equities and credit
- Part 2 - Jobs: The big picture improves, supporting equity and credit
- Part 3 - The Fed favors the wealthy: Good for investors, not middle America