More recently we have seen the impact of the Dodd-Frank Bill and Volker provision within it. Post the financial crisis, various pieces of legislation, including Dodd-Frank and the Volker Rule were put into effect with the goal of reducing risk and increasing the stability of the banking system. While these pieces of legislation may serve to stabilize the banks, they have created unintended consequences for financial markets, including what we see as less stability and higher volatility in fixed income markets. For instance, the Volker Rule effectively limited the ability for banking institutions to engage in proprietary trading of securities for their own accounts. As a result, traditional market makers and liquidity providers (such as the major investment banks) have pulled back on their lending and market making activities due to these regulations and a focus on risk reduction on their balance sheets.
Why is it important to understand such legislation? Mainly because it can shape who ends up owning certain asset classes. In the cases of FIRREA and Basel II, banks became large sellers, creating opportunities for buyers. In the case of Dodd-Frank, it has resulted in greater volatility in today’s high yield market, as many of the market makers that were previously in place to absorb some of the trading volume are no longer there. Yet this volatility can create attractive entry points. Great credit analysis—a pre-requisite for producing returns in this asset class—is aided by the opportunity-set itself, which is a function of the market and the lack of permanent investors created mainly by misinformation and poorly drafted legislation. Over various points in history, we have seen this legislation create opportunity for high yield bond investors.
For more on the history and development of the high yield asset class, a discussion of the legislation and ratings methodologies that have created what we see as opportunities in the marketplace, and comparative historical risk adjusted returns with other asset classes, click here to read our updated piece, “The New Case for High Yield: A Guide to Understanding and Investing in the High Yield Market.”
1 “Panel Lessons of the Eighties: What Does the Evidence Show?” History of the Eighties—Lessons for the Future. Federal Deposit Insurance Corporation, 1997. p. 58.
2 Friedman, Thomas. Dictionary of Business Terms. Barron’s Educational Series, Inc., 2007. “Financial Institution Reform, Recovery and Enforcement Act (FIRREA).”
3 “International Convergence of Capital Measurement and Capital Standards,” Basel Committee on Banking Supervision. Bank for International Settlements June 2006.
This article was written by Tim Gramatovich, CFA, CIO for Peritus Asset Management, the sub-advisory firm of the AdvisorShares Peritus High Yield ETF (HYLD).