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Friday, May 3, 2013

An Unusual ETF That Looks Interestng

Readers of this blog know that I am not a fan of hgh management fees and not much of a believer in active management....

Yet a relatively new ETF that carries high fees and is actively managed looks quite interesting to me.

The ETF is HYLD the Petrius High Yield Bond ETF , it is an actively managed high yield bond fund with a management fee of (ouch) 1.35%.

One reason I am not a fan of actively managed bond funds is that they are often "go anywhere bond fund" like Pimco's Total Return which makes macro bets (positioning) across maturities and types of bonds. Even with Mr. Gross' admirable management record I don't like the fund because in building a bond portfolio one never knows how the fund is positioned. Thus it is impossible to structure a bond allocation with particular targets in terms of credit quality and duration with such a fund. Other funds, even when labelled for a particular part of the market, can drift away from the prospectus title and have a poor record of consistently outperforming the benchmark.

On the other hand, I have felt that there is potential for success in active management of bonds within a defined level of credit quality and duration. After all bond market prices (on a relative basis in the same sector and duration) are determined by the issuer's creditworthiness. This is determined by slower moving and less volatile factors : major changes in income, changes in balance sheet rather than the more volatile  earnings and revenue that determines stock prices.  The ultimate risk to a bondholder is bankruptcy and even in bankruptcy bondholders will receive something and are senior to holders of equity.

 So good credit analysis/active management does have the potential for outperformance.

That is why HYLD looks interesting. It confines itself to a specific sector of the credit market: short term high yield. As I have noted in my credit market review, this sector offers an attractive risk reward profile. The low duration reduces interest rate risk and also diminishes credit risk . While credit spreads have indeed declined already the lower interest rates reduce debt service costs.

Should economic conditions improve that wouldwould increase the debt issuer's cashflow and ability to service debt..effectively reducing the credit risk of high yield bond. While the narrowing of credit spreads between high yield and treasury bonds has raised some warnings of a "bubble" the truth may be that short term high yield has extremely attractive risk/reward characteristics compared to the rest of the bond market.

The index ETF for short term high yield (SJNK) looks attractive and HYLD may be an attractive addition to short term high yield allocation in a bond portfolio.

Petrius explains its methodology here. Essentially it is value investing within the short term high yield sector.
As the manager explains it: in a paper on alpha and beta in bond investing.

What is important for investors to understand about value investing in bonds versus stocks is that we have a natural exit strategy
in that we have a maturity date with a price of par ($100). Value investing in the equity business means that you can own a cheap
stock and it can stay cheap forever. Most importantly, the analysis on bonds is entirely different than stocks. Why? Our returns don’t
depend upon beating expectations or earnings growth or great stories or any of that nonsense. What we care about is the company’s
ability to pay its bills, including our interest payment, until that maturity date, or an earlier refinancing or call. So our analysis centers
on our core philosophy: CREDIT IS EITHER AAA OR D! What we mean by this is that if we believe that the company can pay all its
bills for the foreseeable future, then it is an AAA credit to us. If we believe it cannot, we put it in the “D” camp, which means we feel
it has a high likelihood of default and we will choose not to invest in it

In other words if they can locate a bond with an attractive yield short maturity and good credit prospects as long as the bond is paid back (the exit point) the active market selection will be profitable.

So far so good for HYLD.

Here is a comparison of HYLD  and SJNK

HYLD                                                                  SJNK
Duration                            3.1 years                     1.99 years
30 day SEC Yield                8.1%                         4.07%
% of assets rated below b-  17%                           19.2%

One Year Performance and Volatility are listed below . Clearly on a risk/return basis HYLD looks quite attractive. Interestingly and not surprisingly the outperformance of hyld vs sjnk is almost identical to the yield differential of 4%.

The high total return which is in excess over the yield is capital appreciation due to compression of credit spreads. But going forward an investor in either of these ETFs would be happy with no fluctuation in price and simply  collect the yield of investment grade short term bonds of around 2%. And looking at the relative yields investors in SJNK could tolerate some reversal in the credit spreads and declines in price and still have a total return above that of investment grade bonds. That cushion vs investment grade is even greater for HYLD.

Of course the caveats remain: the fees are .95% above that of SJNK, the fund has been around only since Nov 2010 so the track record is short. Liquidity is not great , a good rule of thumb is never to enter market orders and to always use limit orders, this would particularly the case for this ETF.

Using HYLD in a bond portfolio:
 I have written before about the concept of a credit barbell as opposed to the more common barbell strategy combing long and short maturities to modify interest rate risk.

In a credit barbell one would remain in the same duration but lower the credit risk by combining high and low risk.

A simple and  risk averse strategy would be to combine SJNK, HYLD and the short term treasury ETF SHY.  SHY pays virtually no interest and this point, but it gives a bit of a crisis hedge. Should a serious crisis like in 2008 occur, SHY will likely increased in value.

In 2008 SHY increased in value by 6.6%, short term high yield etfs were not available, but as a bit of a point of comparison intermediate term high yield declined by 24.7% and short term investment grade declined by 6.6%. I would expect short term high yield to show a decline somewhere between that number. Using a conservative number of 20% decline for HYLD that would mean a 50% SHY 25% SJNK and 25% HYLD   portfolio would return somewhere in the are of -7%. Not terrible for a disaster scenario considering the current yield on the portfolio would be that would carry 3%  compared to 1.1% for short term investment grade bonds (VCSH).

And high yield has a strong reversion to the mean. In 2009  JNK returned over 37%

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