We see this as a major problem for passive funds. If we were to look at the largest passive high yield exchange traded fund, iShares iBoxx $ High Yield Corporate Bond ETF (ticker HYG), just how much of this portfolio trades for a price above the typical first call we see of $105? Even with the massive refinancing effort over the past few years, over 50% of the HYG portfolio of issuers trades at or above $105, which represents $9.2 billion in assets! In fact, the average dollar price of this $9.2 billion is $110.1
So investors buying this fund today are paying a massive premium for over half of the fund. Because these funds have no mandate or impetus to sell and capture these premiums by the nature of their passive structures, investors today are building in future principal losses. If rates rise and we do ultimately see a slowing of refinancings, then eventually that principal loss could be amplified as you get closer to that par maturity price.
We see this issue as pervasive with passive investing. A large portion of the high yield market, thus the indexes and the products that track them, has appreciated to huge premiums above call prices, not only leading the potential principal losses, but also a very thin yield-to-worst on much of the market, which ultimately doesn’t bode well for the return prospects. We should note that the 30-day SEC yield is not necessarily a good barometer of prospective return as it does not fully reflect this issue, as this yield metric factors in income less costs over the prior 30 days and period-end price, so it is more reflective of a current yield.
Let us be clear, despite these premiums and low yields on some securities, this certainly does not mean that there is not opportunity for solid returns to still be had within the high yield market. Rather, it means that active management is all the more essential in today’s environment.
Active managers can capitalize on these premiums by selling these securities and locking in their gains, and redeploy proceeds into better yielding securities. There are still plenty of bonds and loans in the market offered by sound companies at what we see as attractive yields. Able active managers can weed out the selective opportunities from the over-valued, low yielding credits in the space.
Investing still involves buying low and selling high. To buy and hold forever is not a strategy. It works when money is rapidly flowing into the asset class, but that pace has slowed in the high yield market and now it is time for active management. For more on the deficiencies of passive management, see our recent piece, “The Necessity of Active Management in High Yield Investing.”