A better way to invest in high yield: solving liquidity, cost and performance issues
key takeaways.
- The combination of attractive long-term returns and income from elevated levels of spread and carry should be a winning combination for high-yield credit
- Unfortunately, fixed-income investors aiming to access this promise directly via bonds or ETFs face issues in three key areas: liquidity, performance and cost
- Our solution has found a better way: combining high-quality treasury debt with the liquidity benefits of credit-default swap indices to access credit risk premia cheaply and efficiently.
On the face of it, high yield (HY) investing offers a compelling combination of attractive long-term returns with strong income potential from elevated levels of spread and carry. Unfortunately, investors aiming to capture this opportunity directly via HY bonds tend to encounter inherent issues. So, is there a better way to access the promise of high yield?
Problem one: high-yield bond markets have major liquidity issues.
Regulations including the Dodd-Frank Act and the Basel Accords have contributed to a severe decline in liquidity in fixed-income markets since the global financial crisis – particularly in corporate bonds. With liquidity widely distributed across bond maturities, large broker-dealers continue to act as market makers and liquidity providers; yet significantly higher balance sheet costs have limited their ability to warehouse risk, sharply reducing dealer inventories.
The problem is particularly acute in high yield. Standard lot sizes for calculating bid-ask costs for a less liquid HY issuer can be as much as 20 times lower than for a large and liquid investment-grade (IG) bond; low trading volumes mean higher trading costs, in turn reducing liquidity.
From swing pricing and entry/exit costs to the gating of funds, the consequences of liquidity constraints in HY can manifest in many ways. ETFs are often touted as a solution, but create a new problem in the form of price-to-net-asset-value (price-NAV) dislocation. This can spike to extreme premium/discount levels exceeding the ‘true price’ of accessing the index – amplifying the cost of realising liquidity just when investors are most likely to seek it.
Problem two: both active and passive high-yield strategies underperform benchmarks.
While persistent underperformance has driven criticism of active management in equities, in corporate credit, the average fund manager outperforms1. However, that outperformance actually comes from IG, with HY mutual fund managers tending to underperform the benchmark.
HY funds tend to be more aligned with their universes, with studies indicating a conservatism bias may cause negative exposure to the credit premium. A negative relationship between fund alpha (excess performance over benchmark) and benchmark credit returns suggests default aversion and avoidance of CCC-graded bonds could be key reasons for mutual fund underperformance.
A passive approach should avoid such biases. Yet, while the largest ETFs in the high-yield space track well against their stated liquid benchmarks, these benchmarks persistently underperform standard HY benchmarks by almost 0.5% per year.2
Problem three: high costs in credit are punitive.
Based on Morningstar data, median ongoing charge figures (OCF) for active HY funds (including fund management costs and management fees) range from 0.7% for institutional shares to as much as 1.4% for retail shares.3
Entry-exit costs are a further drag on fund performance, with attempts to pass on transaction costs to new investors at times of market stress a particular issue. Swing prices are directly linked to actual transaction costs, which hit 2% during the Covid-19 crisis; with bid-ask costs tending to skew in the direction of flow, investors would have therefore paid at least 2% to exit a fund.4
Our solution
Fortunately, we believe there is a more efficient way to access high-yield bond exposure.
Our Systematic Research team has developed a strategy that combines high-quality treasury debt with credit derivatives to overcome the fractured liquidity of the market, target outperformance and mitigate drawdowns.
The team’s research indicates that this innovative approach could sharply lower transaction costs, aid yearly outperformance and produce higher Sharpe ratios than HY benchmarks over time.
