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Credit investors are increasingly focused on high yield exchange traded funds (“ETFs”) given their continued growth. While these ETFs currently account for only approximately 3% of the high yield market, nearly 40% of year-to-date inflows to high yield have gone to ETFs, representing 3-5% of trading volumes versus 1-2% in the first half 2011. In this paper, we will examine the following topics:
- ETF fund structure: Using the same model as equity ETFs, high yield ETFs facilitate liquidity by creating and redeeming shares on a daily basis.
- Implications on market technicals: Volatility has increased in high yield issues that are eligible for ETFs which drives a bifurcation in trading patterns in ETF eligible versus non-eligible bonds.
- What are we are doing about it? We aim to find asymmetries in the market driven by ETFs and capitalize on the opportunities.
- ETF performance: ETF gross returns have lagged the index by 0.75% annualized since 2010.
High Yield ETF Basics
ETFs provide investors access to the high yield market through equity securities. In 2007, two ETFs were launched for the high yield asset class: iShares iBoxx High Yield Corporate Bond Fund (“HYG”) and the SPDR Barclays Capital High Yield Bond ETF (“JNK”). Together, they account for approximately 95% of high yield ETF assets today. Both the HYG and the JNK aim to track benchmark very liquid high yield indices.
Both funds are open-ended, which means when capital flows in or out of the ETF, shares are created or redeemed by purchasing or selling the underlying high yield bonds. The ETF managers, Blackrock and State Street Global Markets, provide approved market participants three lists daily: current bonds held, creation basket bonds, and redemption basket bonds. Creation or redemption units do not need to contain a comprehensive basket of bonds held in the ETF. Instead, the managers aim to use share creation and redemptions to balance their portfolios to mirror the benchmarks more closely making share creation less expensive and allowing for fewer trading costs.
Despite this mechanism, the ETF share price can trade at a premium or discount to the net asset value (“NAV”) of the underlying bonds depending on demand and intraday trading. ETF managers try to limit how much the NAV can deviate from the share price though ETFs generally trade at a premium to the NAV given the bid-ask spread of the asset class. The greatest aberrations typically occur during times of market frenzy or duress and rarely last more than a couple days.
Over the past year, JNK has traded closer to NAV than the HYG.
ETF Purchases and Implications on Market Technicals
Specific rules govern which bonds ETFs can purchase. For example, in most instances, the JNK only purchases the largest bond of each issuer, which drives its lower issue count relative to the HYG. ETF buying preferences create trading anomalies within capital structures and between liquid issuers included in the ETFs and those which are excluded.
We have witnessed yield differentials among ETF eligible and ineligible ETF eligible bonds which are highly correlated with fund flows and market sentiment. The below chart examines highly liquid bonds which are included in the ETFs versus highly liquid bonds which are not eligible either due to maturity constraints, total issuer debt, or years since issuance. During market turmoil of Q3 2011, ETFs faced outflows that drove the yields of ETF eligible bonds to trade at a discount to the rest of the market. In the end of Q4 2011 and into 2012, the bid for ETF bonds has remained elevated relative to the broader liquid market.
As expected, ETF eligible bonds face greater volatility than non-ETF eligible securities. We expect this trend to continue.
ETFs are also impacting the primary market. Because banks are now pitching new deals with the ETF buyer in mind, they create capital structures designed to fit within the issue size, ratings, and maturity parameters of the liquid indices. In certain instances, we have seen the upsizing of capital structures to permit inclusion.
Our Plan Regarding the ETFs
We monitor our portfolios and invest with ETFs in mind.
- For large capital structures, we swap into similar non-ETF bonds. We maintain a high level of liquidity, often pick up spread and yield, and relative downward pressure on asset prices from outflows.
- Participation in new issue which is ETF eligible is often accretive given ETF purchases in the secondary.
- We have daily internal monitors which track the issuers the ETFs are overweight and underweight. We will opportunistically buy or hold bonds which ETFs are underweight as they will need to repurchase them to rebalance. Avoid/sell bonds which ETFs are overweight given they will be the first assets sold upon redemptions.
ETF gross returns have lagged the liquid credit indices by approximately 0.7% in more normalized markets from 2010 to the first quarter of 2012.
A Note on Costs
Direct and indirect costs exist when investing in ETFs. Funds charge management fees of 40 to 50 basis points on assets. ETF eligible assets can trade at premium to the rest of the capital structure of the same issuer anywhere from 25 to 75 basis points. Lastly, given that ETFs trade at a premium to the NAV of the assets, investors pay on average approximately 50 basis points (though this varies according to market sentiment). This implies total average fees of approximately 1.5%.
About Sankaty Advisors
Sankaty Advisors, LP is a global leader in the management of fixed income and credit instruments. With approximately $15.8 billion of committed capital as April 1, 2012, Sankaty invests in a wide variety of securities and investments, including leveraged loans, high‐yield bonds, distressed/stressed debt, mezzanine debt, structured products and equities. Through our numerous funds, we have the ability to invest in every level of a company’s capital structure from secured debt to equity, and can also provide capital to growing companies with unique financing needs.
Our investment process is characterized by detailed business and financial analysis. We combine a consulting-based approach to industry, competitor and business analysis with an in-depth examination of a target company’s financial performance and capital structure. Our goal is to select the best industries, the best companies and the best relative value among the many securities each company offers.
Sankaty has a world-class team of over 85 investment professionals with extensive experience analyzing and managing high-yield investments. Our headquarters is in Boston, with additional locations in Chicago, New York and London.
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In this material Sankaty Advisors, LP and Sankaty Advisors, Ltd., are collectively referred to as “Sankaty Advisors”, which are the credit affiliates of Bain Capital, LP. This presentation expresses the good faith views of the author as of the date indicated and such views are subject to change without notice. The original version of this presentation on the date ascribed within may have been updated or modified for purposes of this posting. Sankaty Advisors has no duty or obligation to update the information contained herein. Further, Sankaty Advisors makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss.
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