Options in High Yield Investing

We have spoken quite often over the years about our passion and profession here at Peritus: high yield corporate debt. Just what is high yield corporate debt and what does it offer investors?  These are questions we have answered in our whitepaper The New Case for High Yield. Once the case is made for investing in high yield, the question then becomes how do investors access this asset class and what are they getting when they buy these “high yield” vehicles?  Then there is the debate between active and passive managers and is it all about returns, liquidity, and size.

You have two primary choices when investing in high yield bonds: an exchange traded fund (ETF) or a mutual fund.  A mutual fund is a pool of high yield debt that has to be bought and sold each day when there is money either flowing into or out of the fund.  ETFs do not have these same money flow issues, as shares of the ETF can be exchanged or redeemed intraday by the market makers and if there is a large redemption, an ETF manager can exchange securities and or cash; thus, not having to liquidate securities on a daily basis to satisfy redemptions.  This can reduce volatility in the underlying securities in the portfolio. Mutual funds can be complicated and expensive; there are many different fee structures, A and B shares, back-end load fees, front-end load fees, early redemption fees and on and on.  ETFs have a very simple fee structure and no redemption fees. With mutual funds, the only liquidity you get is at the end of the market close, as there is no intraday trading.  ETF’s trade on a stock exchange, trade intraday and generally have full liquidity, just like Microsoft or Apple or Safeway.  As per what the mutual fund owns, holdings are only posted at the end of each quarter.  ETFs are fully transparent and holdings and portfolio stats are posted on a real time, daily basis.  For example, if you go to www.advisorshares.com and take the 60 seconds to register and you will see the holdings and other information on all of their ETF’s, including the Peritus High Yield ETF (HYLD).

When looking at the high yield manager/vehicle universe, the various high yield/high income mutual funds and ETFs are all lumped together.  The reality is there are stark differences between the two large high yield ETFs (HYG and JNK), the open-end mutual funds (for example Loomis Sayles and MainStay Funds) and Peritus.  All of us claim to be “high yield” managers of corporate debt; however, some are only dressed as high yield managers but have drastically different holdings than high yield corporate debt.

Let’s spend a few minutes talking about investment policies and what is in the various products.  Generally speaking, ETFs have a narrower investment policy, whereas mutual funds can buy just about anything.  For the most part, the high yield ETFs stick to high yield corporate debt, whether it be notes, convertibles, preferred stock or, in limited cases, high yielding common stock.  Mutual funds are much broader with what they can invest in, I guess the reason being is they do not have to have collateral that has the ability to be hedged or be liquid on a daily basis.  I was looking through the holdings of two of the more prominent mutual funds out there, Loomis High Income Fund and MainStay High Yield Fund.  MainStay has holdings in asset backed securities, common stocks, preferred stocks, REITS, warrants and repurchase agreements.  Loomis owns commercial mortgages, mortgage pass through notes, bank discount notes, European bank notes, Irish government bonds, Italian government bonds, home equity loan trusts, Portugal telecom bonds, receivable funding notes, preferred stocks, common stocks, warrants and foreign country currencies.  Is this high yield investing? Absolutely not.  The reason they have to invest in these areas is because they have become so big, if they were to just invest in high yield corporate debt, they would simply mirror an index.  Because of their size, they can’t be nimble in finding opportunities in the high yield market, and instead stretch into these other asset classes and take on excess risk for higher returns.  Investors need to look to the underlying holdings of the funds in which they are investing.

Turing to the two largest high yield ETFs, they mirror an index, owning basically the largest, most liquidity names in the market. Credit fundamentals and the company’s liquidity and outlook are irrelevant and no research is done on any of the holdings.  So their holdings end up including companies that have to rely on credit markets continuing to let them extend maturities and tranches of debt because they are >10X leveraged.  If you even took one accounting class you would understand that this is simply equity dressed in a bond, as capital structures levered this high are generally not sustainable.  What is the expected recovery for this highly leveraged paper? I would guess cents on the dollar.  And, if you look through the economy, are all industries doing okay or plugging along?  No way.  Take coal for example, between the EPA decisions and the conversion to natural gas by many of the power producing companies, an avalanche has begun where you are seeing companies being swept down the mountain into bankruptcy.  There will be a time to look for possible investment in this industry as the survivors emerge.  Is not the object of investing to buy low and sell high, buy when the blood is ankle deep and sell when the general public sees it was just a scratch?  You can’t own the whole high yield market as you will eventually pay the price because you are forced to in essence buy high and sell low.

You would think that high yield investors would want exposure to the best securities in the best industries on a forward looking basis. We believe this can only be done through an actively managed portfolio.  Many mutual fund options say they are actively managed, but, as mentioned above, they are not offering you a pure allocation to bonds in the U.S. high yield market and they hold hundreds of credits, so how could you do proper due diligence on each company, let alone governments of Italy, Ireland and others, and then look at that holding in the context of the larger economy?

You can listen to the propaganda that is being thrown at you by buying the biggest, and most often cheapest, ETFs or mutual funds, but you will get what you pay for.  The decades of just buy the market at the lowest cost and dollar cost average does not work.  Just look at the equity market returns over the last decade. All ships will not rise going forward in high yield, or any asset class for that matter.  Real risk has been masked over the last three plus years due to money flows. These risks need to be actively managed and the underlying holdings need to be understood and analyzed.  True high yield corporate bonds offer what we see as great value to investors, but make sure that you really own corporate bonds, not something else, and make sure that you own the right credits within this asset class.  That’s where true active managers add value.

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