opportunity to invest in a moderated, pasteurized instrument with managed risks and the tempting potential of outsized returns.
High yield corporate bonds have been the rock stars of the bond ETF space, delivering excellent performance and seemingly low risk until just over a year ago, when things started to unravel. The AdvisorShares Peritus High Yield ETF (NYSEARCA:HYLD), an actively managed ETF, was among those hit the hardest.
HYLD is not a passive, index-tracking fund; the fund’s management carry out due diligence on all the corporate bonds the fund invests in, and this is accompanied by an active style and high expense ratios. Theoretically, HYLD should produce superior returns provided that the underlying bonds don’t default.
HYLD’s Investment Strategy
The philosophy that underpins the fund’s active management strategy is interesting: by focusing on illiquid securities in secondary markets, where pricing inefficiencies can prevail, HYLD’s managers believe that it is possible to realize a high yield income stream. In large part, this investment philosophy is what accounts for HYLD’s hyper-active style.
The AdvisorShares prospectus describes the strategy thus:
Peritus takes a value-based, active credit approach to the markets, primarily focusing on the secondary market where Peritus believes there is less competition and more opportunities for capital gains. Peritus de-emphasizes relative value in favor of long-term, absolute returns.
With exposure to these illiquid corners of the market, the fund’s portfolio is surprisingly well diversified, and is should be immune to any single-sector shock or collapse. The chart below shows the fund’s varied exposure across market sectors.
However, one of the more worrying aspects of this approach though is this: a fund that seeks alpha entirely in inefficiently priced markets is by definition one that lies at the mercy of the types of inefficiencies that give rise to concentrated risk.
So how well has this strategy worked, and what went wrong in 2014?
Since its inception in October 2010 until September 2014, HYLD produced solid returns, often beating the Barclays Corporate High Yield Index. This performance led to an influx of investors in the ETF at a time when Stock Index returns were beginning to flag, and seemed to support the active strategy that its managers were pursuing.
In the final quarter of 2014, however, returns plummeted as concentrated risk came to call in the form of parallel corporate defaults. Since then, HYLD has demonstrated little ability to recover and has trailed all the comparable benchmarks (albeit without further expanding the gap between them). In many ways, a chart of the fund’s NAV resembles the performance of a flawed option-writing fund, with steady and consistent growth punctuated by sporadic, devastating declines: this is also an apt way of interpreting the risk of high yield found here.
Paying for Risk
Because HYLD invests almost exclusively in illiquid securities, it also has a high expense ratio (1.23 through 2015). Because liquid bonds are more heavily traded the process of price discovery is generally more efficient, so the market helps to balance the risk/return profile of any ETF investing in them.
But for HYLD, with the additional risk comes additional costs. While ever the fund management’s ability to successfully evaluate and select assets to invest in prevails, then the exceptionally high yields will more than offset the additional expense. But as soon as this strategy, which is necessarily aggressive in order to capitalize on potentially high reward opportunities, backfires, then investors in the ETF are going to see substantial losses of the kind that late 2014 produced.
The Dark Side of High Yield Credit Risk
Where investors in stocks may vacillate between capital growth and dividend income, the bond market has always been about one thing: yield. Yield is the principal income that swells the value of an ETF such as HYLD. The class of sub BBB- rated company bonds that HYLD includes in its portfolio (of which 1.19% are not rated) pay high coupon rates, but more importantly they offer phenomenal yield to maturity.
Peritus, HYLD’s management, take what might be termed a “divergent view” on credit ratings and those who follow them:
Peritus views credit as either “AAA” or “D” (either it is expected to pay its obligations or it isn’t) and places limited value on the rating agencies and their backward looking methodologies. Peritus exploits the fact that most fixed income investors continue to use ratings as one of their primary investment tools.
While ever this view is consistent with market reality, which is to say that if all the required payments on these company’s bonds are actually made, then even after expenses the fund’s investors are looking at excellent yield to maturity returns in the region of 16%.
The downside of this performance is significant credit risk. One wonders how many of HYLD’s shareholders, given the opportunity and resources to carry out their own due diligence on these companies, would then see their bonds as an attractive proposition. It might be argued, of course, that the level of diversity present in the ETF sweeps away these problems, but HYLD’s sharp decline seems to confirm that credit risk is often concentrated, as the fates of individual companies are swept along with the same economic tides that lead to mass defaults.
It is questionable whether the fantastic returns of these bonds ever really compensated for the overwhelming credit risk to shareholders.
Beware the Hidden Risks of High Yield
With a total of only 83 investments currently underlying the portfolio, the potential impact of even a single default can be significant for the fund.
Although HYLD will doubtless perform very well in virtually any given period, the specter of concentrated risk and the catastrophic losses it brings lurks unseen at the heart of the fund’s investment strategy. Prospective investors should carefully consider whether they would want to be holding HYLD in a month when its value plummets 30%, wiping out several prior years of accumulated gains.
Despite the hype, the potential for higher yields comes with significant downside risk, often concealed and hard to quantify, and the equity traps that these declines produce can be deeper and harder to escape than those encountered in passive bond ETFs focused on highly liquid issues. Indeed, that’s why they used to call them “Junk Bonds”!
About the Author
Alexander Pearson is an online financial journalist. He has contributed market analysis, industry news, and educational articles to a variety of sites including Seeking Alpha and OilPrice.com. His background is in quantitative trading and strategy development.
Alex’s main specialization is in the brokerage industry, and he is the editor of BestBrokerDeals.com, an online portal for broker promotions providing a wide range of tools and resources to research and compare discount brokerage firms.