Think high-yield bonds, but with better liquidity – 3 advantages of a more efficient approach

High-yield (HY) bonds offer an attractive combination of spread, carry and income. However, both active and passive strategies aiming to capture the this opportunity tend to encounter liquidity, performance and cost problems – materially impacting realised returns.

In a previous article, we covered these issues and previewed a more liquid, cost-efficient approach for accessing the upside of the asset class. In this article, we explain the basic principles of this strategy and its potential to provide superior liquidity and lower costs than conventional HY products.

Read also: Key problems with high-yield bond investing – and steps toward a solution

What causes high-yield liquidity shortages?

HY investors can suffer specific liquidity problems caused by several factors. These are:

• Regulatory constraints. In a market not suitable to exchange trading, broker-dealers act as liquidity providers. But regulations seeking greater balance-sheet strength have reduced how much inventory they can hold, resulting in shallower trading pools
• Low trading volumes. In HY, the lot sizes – or standardised quantity traded in a single transaction – which are used to calculating bid-ask costs can be 10-25 times higher than for investment-grade (IG) bonds. Since greater lot sizes result in fewer trades, this reduction in volume leads to higher costs when investors convert HY assets to cash
• Price-NAV dislocation. Exchange traded funds (ETFs) are often touted as an efficient  solution but only create the illusion of liquidity. Market shocks dislocate the price-to-net-asset-value (price-NAV) of ETFs, driving up the cost of liquidity when it is most needed.

How can investors access high-yield bond returns with better liquidity?

Liquid access to HY bond returns can be achieved by using a more efficient way to harness the underlying risk premia – credit and rates. Rather than being a monolithic instrument, corporate bonds provide a combination of rates and credit exposure that drives risk and returns.¹ By using credit derivatives alongside liquid government bonds, these risk exposures can be replicated and combined to create a synthetic exposure to HY return drivers – but with superior liquidity.

Credit risk drives HY risk and returns – this must be reflected in a synthetic replication. Further down the ratings spectrum, the split between rates and credit risk changes significantly, with the latter dominating risk and returns (see Figure 1). Understanding this is fundamental to replicating a bond using highly liquid government debt and credit derivatives.

FIG 1. Credit and rates risk premia across the corporate bond ratings spectrum²

Credit-default swap (CDS) index derivatives and high-quality government debt can replicate the credit and rates premia in HY – but with advantageous liquidity. In our liquid credit strategy, we use high-quality sovereign, supranational and agency (SSA) bonds to replicate the rate component of the corporate-bond index. For credit exposure, we sell protection on high-yield credit-default-swap (CDS) indices in the US (CDX HY) and Europe (iTraxx Xover).³ The combination of cash flows from the  CDS index protection seller with those from SSA bonds replicates the cash flows of the underlying corporate bond.⁴ We then weight the two geographies to align with the global corporate HY benchmark.

FIG 2. Methodology for building a liquid credit bond replacement⁵

Read also: Capturing high-yield carry: the benefits of a CDS-based approach

As drivers of credit risk, CDS are key to a liquid HY solution. For a corporate bond, the investor receives an excess spread for taking on exposure to the possibility of default. Similarly, the protection seller receives the CDS spread to compensate for default risk. Every six months, CDS indices ‘roll’ as a updated series are constructed. Liquidity is usually concentrated in these ‘on-the-run’ series (although the older ‘off-the-run’ series also trade). This makes them the most liquid type of instrument in credit markets globally, which is a key reason why many market participants use them to implement top-down market views.

FIG 3. Advantages of CDS indices over bonds⁶

Three liquidity advantages from a liquid approach to high-yield bonds

Liquidity in HY markets is affected by trading costs and volumes, and the dynamics of bond indices, which result in significant unavoidable turnover. A liquid credit strategy offers solutions to each of these factors.

1. Reduced trading costs

Bid-ask costs for trading CDS indices are an order of magnitude lower than for HY bonds. Trading costs can be measured in a multitude of ways, but the bid-ask spread is our preferred measure. Costs are calculated for a standard lot size, which can be as high as USD 5-10 million notional for a large and liquid IG bond but as low as USD 200,000 to 1 million notional for a less liquid HY instrument. Based on bid-ask costs for bonds and CDS indices⁷, the bid-ask of the derivatives is an order of magnitude lower than for cash bonds. Average transaction costs for CDS indices are 10-15 bps for HY, but are 5-10 times higher for cash bonds (see Figure 3).

Average transaction costs for CDS indices are 10-15 bps for HY, but are 5-10 times higher for cash bonds

FIG 4. Trading costs: bonds vs derivatives⁸

2. Better trading volumes

The liquidity of a single credit derivative can rival that of an entire cash-bond universe. Trading volumes also meaningfully impact cost: in general, increased trading in an instrument can meaningfully lower the cost of trading. Taking the volumes traded in US cash bonds and the US HY index derivative as an example, we find the median notional volume traded in the US HY contract each month is almost as large as the cash value traded in all the bonds within the US universe combined.^9,10

FIG 5. Trading volumes: bonds vs derivatives ¹¹

Trading volumes are strongly correlated to rises in credit spreads – volumes tend to spike in during macro shocks. In stressed periods, trading volumes in CDS indices are even higher, eclipsing the total trading volume of all cash bonds (see Figure 5). This enhances the ability of a liquid credit strategy to provide liquidity in times of stress if so desired.

In stressed periods, trading volumes in CDS indices are even higher, eclipsing the total trading volume of all cash bonds

FIG 6. Trading volumes with credit spreads¹²

Read also: Bonds, ETFs or CDS – in high yield, which is more resilient to liquidity shocks?

3. Lower turnover

Natural turnover costs for CDS indices are four-to-five times lower than for HY indices. Index dynamics alone generate unavoidable natural turnover of 30-40%, incurring costs as new issues enter an index and bonds of lower than 1-year maturity exit. Using liquidity cost scores¹³, we calculate the cost of this turnover at around 5-6 bps per year for IG and 12-15 bps per year for HY cash bond portfolios (see Figure 4). In contrast, for they typical six-monthly roll of CDS indices, we estimate annual costs to be in the range of just 1 bp per year for IG and 3-4 bps per year for HY.

FIG 7. IG and HY cash bond turnover and trading costs (rolling 12 months)¹⁴

Three liquidity advantages available to high-yield bond investors

Reduced trading costs, better trading volumes and lower turnover are three ways that a liquid credit strategy can provide significantly improved liquidity compared to a portfolio of HY cash bonds. In the next article in this series, we demonstrate the outperformance potential a liquid credit solution can provide over the long-term.