Last year, the winning bet in fixed income was on falling interest rates, and while investors are still keen on finding yield, they’re starting to look for it in very different places.
That concept came into sharp focus earlier this month, with the rollout of the Pyxis/iBoxx Senior Loan ETF (SNLN), a security that’s emblematic of changes going on in the world of fixed-income investing.
Specifically, investors still want the yield, but they’re increasingly interested in finding high-yielding securities by isolating credit risk while avoiding interest rate risk. Crucially, ETF sponsors are tuned in, and are rolling out and planning funds that will fit the bill perfectly.
So, I wanted to look closely at some of these products to get perspective of what investors have in store for them.
But first, a little background is in order.
For those who have forgotten, long-term Treasury funds like the Vanguard Extended Duration Treasury ETF (EDV) and the Pimco 25+ Year Zero Coupon U.S. Treasury ETF (ZROZ) returned more than 50 percent in 2011.
If last year’s strong move caught a lot of people by surprise—especially since it came in a year when U.S. sovereign debt lost its completely risk-free “AAA” rating—a repeat would appear to be extremely unlikely since rates have very little room to go any lower.
This year, junk bonds loomed as a new frontier in the quest for yield, but they too are starting to lose some luster.
After all, high-yield-oriented ETFs nearly doubled their assets in 2012, with the $15.84 billion iShares iBoxx $ High Yield Corporate Bond Fund (HYG) and the SPDR Barclays High Yield Bond ETF (JNK) leading the charge. However, recently we have seen some outflows in the space.
Credit spreads on high-yield debt have narrowed, and worse yet, bond covenants are being relaxed for issuers. What that means is that bondholders are not only taking on interest rate risk but, should default rates rise, they may have fewer opportunities for recourse than in the past.
So what to do?
As I said, Pyxis’ SNLN is part of a relatively new wave of product coming on the market that zeroes in on high-yield exposure to credit, while seeking to take interest rate risk off the table.
Incidentally, the Pyxis ETF isn’t the first to pursue the senior loan space.
It will compete against a number of other funds, notably the first of its kind, the PowerShares Senior Loan Portfolio (BKLN), which has gathered an impressive $1.27 billion in assets since its launch in March 2011, which suggests how open investors are to alternative sources of yield these days.
Both funds give access to senior loans, which are variable-rate notes from noninvestment-grade rated issuers. The allure of both funds stems from providing high-yield credit exposure, while mitigating interest rate risk. They achieve this by being tied to the London interbank offer rate (Libor), which offsets any rise in interest rates.
Additionally, two recent registrations from FirstTrust and Market Vectors for high-yield funds that will go long high-yield debentures while shorting Treasurys aim to deliver a similar pattern of returns, with exposure to credit-driving returns, all while mitigating interest rate risk.
How Do These Funds Stack Up?
If pure credit exposure is what investors want, how do the available funds and those in the product pipeline meet this goal?
Since doing holdings-based analysis is problematic for the senior loan portfolios, I decided to measure the historical sensitivity to changes in both interest rates—as measured by the 5-Year Constant Maturity Treasury; and in spreads—as measured by the Option Adjusted Spread of the Barclays High Yield Bond Index (Bloomberg Ticker:LF98OAS).
Additionally, I included HYG and JNK in my analysis to draw comparisons between traditional approaches to high-yield bonds and senior loans.
A few caveats are in order:
- Since SNLN and BKLN have relatively short trading histories, I used underlying index data rather than fund data for the analysis. This allows for more stable pricing and greater consistency of the data. While not perfect, this approach does identify what investors can expect from the fund’s strategy.
- Not to sound cliche, but past performance doesn’t indicate future results. Clearly, we have seen some unprecedented moves in rates and spreads in the past two years, which may not persist going forward. However, considering these are index-tracking vehicles with stable methodologies, the sensitivities to rates and spreads aren’t likely to change dramatically overnight.
- I used monthly returns for the index and monthly changes in yields and spreads to do the multiple regression analysis to limit some of the noise often present in fixed-income data due to pricing and strike time differences.
- Negative betas, while possibly confusing, make perfect sense, as they reflect the inverse relationship between rates and prices.
The analysis had some expected results and some surprises.
Investors in JNK and HYG carry significantly more exposure to interest-rate shocks than SNLN or BKLN.
However, I expected the senior loan funds to have exposure of close to zero to the medium-term interest rate changes, but the exposure was surprisingly high, with a beta in the 0.7 range.
One explanation may be the extraordinarily flat shape of the current yield curve in the short and medium term. Also, with an adjusted r-squared of roughly 0.8, there’s still a significant portion of returns unexplained by interest rates and spreads. This may be due to most senior loans being tied to the Libor. Still, to me this was an unexpected surprise.
The spreads explained the vast majority of the returns in all four cases—again, not terribly surprising considering the lack of movement in the short and intermediate part of the yield curve.
The lower betas for BKLN and SNLN, -2.9 and -3.1, respectively, compared with HYG’s and JNK’s -4.0 and -4.4 readings, were in many ways of greatest interest to me, as they signaled that the senior loans do indeed show lower sensitivity to moves in spreads.
Considering the spread compression we’ve seen in 2012 and the lack of upside that’s currently available from downward moves in interest rates, senior loans stand to continue to gain traction with ETF investors hungry for yield.
|Beta to 5-Year Constant
|Beta to Barclays High
Yield Index OAS
At the time the article was written, the author had no positions in the securities mentioned. Contact Gene Koyfman at firstname.lastname@example.org. Follow Gene on Twitter @GeneKoyfman.
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