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

High yield (HY) can offer a compelling investment case for fixed-income investors, providing an attractive proposition of spread, carry and income. Unfortunately, however, both active and passive investors aiming to capture this opportunity via HY corporate bonds often encounter three typical problems: liquidity, performance and costs.

In this, the first in a series of four articles on overcoming these challenges, we explore the key factors within these problem areas – and introduce a liquid, efficient, low-cost solution for accessing HY returns. 

1.    The problem with liquidity

Liquidity in fixed-income markets has suffered a structural decline since the global financial crisis. Regulations introduced in the wake of the global financial crisis, such as Dodd-Frank and the Basel regulations, have contributed to severely fractured liquidity in fixed income – particularly in corporate bonds. The root causes lie in the over-the-counter nature of fixed-income trading, along with an investor base largely made up of long-horizon institutional investors.

Liquidity tends to be widely distributed across bond maturities and so is not conducive to exchange trading; large broker-dealers therefore continue to act as market makers and liquidity providers. However, tighter regulation has inhibited their ability to warehouse risk by significantly raising balance-sheet costs, resulting in a steep drop in primary dealer inventories (see Figure 1). This has profound implications for fixed-income liquidity.

FIG 1. US corporate-bond inventory vs total universe¹

 
Low trading volumes mean high trading costs, which mean lower liquidity. The ease of converting assets to cash is affected by trading costs, which are themselves impacted by trading volumes. At USD 200,000 to USD 1 million notional, standard lot sizes for calculating bid-ask costs for a less liquid HY issuer can be 10-20 times lower than for a large and liquid investment-grade (IG) bond at USD 10-20 million. By comparison, standard lot sizes used for CDS indices are as high as USD 100-200 million for HY indices. Figure 2A shows bid-ask costs (our preferred measure of trading costs) for HY bonds in EUR and USD, while Figure 2B shows trading volumes for US HY corporate bonds relative to the size of the US HY universe, which remain at multi-decade lows relative to total market size in the wake of the Covid-19 pandemic.²

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

FIG 2. High-yield trading costs and volumes over time^3,4 

 
ETFs create only an illusion of liquidity. From swing pricing and entry/exit costs to the gating of funds, the cost consequence of liquidity constraints in HY can manifest in many ways. Exchange traded funds (ETFs) are often touted as a solution, but in reality, create a new problem – in the form of price-to-net-asset-value (price-NAV) dislocation. This can spike to extreme premium/discount levels that exceed the ‘true price’ of accessing the index in illiquid trading environments. Figure 3 shows how price-NAV can hit discounts of nearly 2% in extreme selloffs, but neared a 5% premium during the post-Covid recovery. Such dislocations add hugely to the cost of realising liquidity – and peak at the moment when investors are most likely to seek it.

FIG 3. Dislocations between HY ETF prices and net asset values⁵

 

2.    The problem with performance

Actively managed HY funds tend to underperform, in general. Persistent underperformance in the past three years has led to growing criticism of active management in equities. Proponents of passive management blame the lack of persistence in fund manager alpha beyond standard factors for the issue.⁶ In their defence, active managers point to concentration of performance to justify recent underperformance. In corporate credit, the average fund manager actually outperforms, but outperformance is largely limited to IG-benchmarked funds⁷, with active HY mutual fund managers tending to underperform on average.⁸ In contrast, active credit hedge funds tend to outperform (see Figure 4). 

FIG 4. Average monthly performance: HY credit hedge funds and HY credit mutual funds⁹

 

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

FIG 5. Performance comparison: HY index vs HY mutual funds¹⁰

 
Passive HY products also underperform. In principle, a passive product should avoid the inherent biases of active management. The two largest ETFs in the high-yield space – namely the iShares iBoxx USD High Yield Corporate Bond ETF (HYG) and the iShares EUR High Yield Corporate Bond UCITS ETF (iHYG) – do indeed track well against their stated benchmarks gross of fees.¹¹ However, when the liquid benchmarks used for these ETFs is compared to the standard HY benchmarks, the liquid benchmarks persistently underperform by almost 0.5% per year. Analysis of this indicates that the underperformance of liquid indices is driven by security selection effects, indicating that there is indeed a cost of liquidity if we remain within the universe of corporate bonds.

FIG 6. Performance comparison: HY ETF returns (gross) vs standard and liquid benchmarks¹²

 

3.    The problem with cost

Running costs walk back long-term performance. The running costs for funds include both fund management costs and management fees which contribute to the fund ongoing charges figure (OCF).¹³ For active HY funds in particular, OCFs tend to be high. Based on data from Morningstar, the median OCF level for institutional shares is almost 0.7% (see Figure 7), while fees for retail share classes are substantially higher at around 1.4%.

FIG 7. Distribution of ongoing charge figures for HY institutional share class strategies¹⁴

 
Swing pricing can take long-term performance even lower. On top of running costs, entry-exit costs – particularly swing pricing – are a further drag on fund performance. Swing pricing is usually applied when market stress drives significant flows, and aims to pass transaction costs to new investors instead of them being borne by the overall fund.¹⁵ While funds rarely provide data on swing factors, they are directly linked to actual transaction costs, which rose as high as 2% during the Covid-19 crisis (see Figure 2A). Given that the bid-ask tends to skew in the direction of flow, investors exiting the fund would have likely paid at least 2% to exit at the peak of the crisis. 

Finding a solution

Together, the issues deriving from these three problem areas are a major drag on the potential total returns offered by HY as an asset class. However, we believe a relatively simple and liquid approach to investing in credit markets exists that addresses these issues: a ‘liquid credit strategy’ that combines high-quality treasury debt with credit derivatives. In the following three articles in this series, we will explain why we see this as an effective solution that provides better liquidity, higher performance potential and more effective defensive positioning.