There is no doubt that liquidity has moved to the forefront for investors in the high yield market.  In our commentary last week we looked at the concept of liquidity and how post-financial crisis regulations have impacted dealer inventory, but despite that we are still seeing solid turnover within the high yield market, just at lower prices (see our piece, “Understanding Market Liquidity”).

As we further the discussion on liquidity, let’s look at one of the main structural features of the large passive, index-based ETFs in the high yield market.  The largest high yield passive ETFs have minimum tranche size limitations, seemingly based on the concept that a larger tranche size equates to additional liquidity.  For instance, the SPDR Barclays High Yield Bond ETF (ticker JNK) tracks the Barclays High Yield Very Liquid Index, which includes high yield bonds with a minimum of $500mm outstanding and the iShares iBoxx $ High Yield Corporate Bond ETF (ticker HYG) tracks an index that only includes bond tranches $400 million and above and from issuers with more than $1 billion of outstanding face value.¹  But if “liquidity” means that prices aren’t impacted when there is selling pressure, it seems that tranche size may not matter all that much.

For instance, as we look at the broad Bank of America Merrill Lynch High Yield Index, over 50% of the individual tranches are under the $500mm threshold.²  If a large tranche size equated to much improved liquidity, one would think that we would see these large tranche-sized bonds hold in much better from a pricing perspective as we face selling pressure.  However, in looking at the lowest priced individual bonds within the high yield index, the average price on all tranches trading at or below $75 is $558mm.³  This would indicate to us that the current liquidity induced selling pressure is hitting large and small tranche sizes alike, so the minimum tranches sizes by the index-based products don’t seem to alleviate the “liquidity” concerns.

As we noted in our writing last week, the turnover in the high yield market remains strong.  We are seeing trading in the high yield market, but just not at the prices people want.  With the recent regulations and curtailed market making activity by the investment banks and lower dealer inventory, we are seeing larger gaps down in prices in the face of selling pressure due to people leaving the asset class and mutual and exchange traded funds dealing with redemptions.  The banks appear to be using their cash to support the newly issues bonds as those have held in very well during this time of volatility, but they have backed away from much of the rest of the market.  Beginning in late 2014, throughout 2015 and so far in 2016, money has left the high yield asset class.  As this happens, mutual funds, ETFs, and other funds sell securities to create liquidity for investors.  As these funds sell what they can, it is leading to broad market price declines virtually across the board in high yield and it would appear that it is hitting small and large tranches alike, so the structural feature of minimum tranche sizes in the passive ETFs may not be providing the protection many had expected it would.  We have always believed that this structural feature actually served as a disadvantage because it eliminated a large portion of the high yield market in which we as active managers have traditionally found value.

As we look at today’s high yield market, we believe the flexibility to access the entire market and take advantage of the various opportunities within it is all the more essential, as is the ability to avoid certain credits.  With this broad selling pressure over the last year and a half, we are seeing many credits with relatively low leverage metrics and still generating free cash flow facing big bond price declines, but we believe the long term viability and fundamentals of many of these credits remains solid.  We are even starting to see companies take advantage of the steep discounts on their bonds and use their free cash flow to buy back bonds, reducing their debt load and interest costs.

We do believe the volatility in the high yield market that these post-financial crisis regulations helped create is here to stay and seems to be impacting both larger and smaller tranche size bonds alike.  However, we believe in this environment, so many yield and potential capital gains opportunities have been created within the high yield market, providing what we see as an attractive hunting grounds for active managers who are able to access the entire high yield market and focus on the best opportunities within it—the credits they see as fundamentally solid versus the credits that they see as vulnerable in this economic environment.

1  Fund restrictions sourced from the ETF prospectus and summary prospectus at https://www.spdrs.com/product/fund.seam?ticker=JNK and http://us.ishares.com/product_info/fund/overview/HYG.htm.  Size limitation based on the underlying indexes for each fund.  The fund may use a representative sample of the underlying index, which means it is not required to purchase all securities in the underlying index.  Both funds may invest up to 20% of the portfolio in assets not in the underlying index.

2 The Bank of America Merrill Lynch High Yield Index monitors the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.  Index data sourced from Bloomberg. Data based on the index constituents and tranche face value as of 2-11-16.

3 Data based on the Bank of America High Yield Index and constituents and pricing as of 2-11-16.