A better way to extract high yield returns? | Insight Investment

In markets like high yield, passive solutions are hampered by costs and difficulties accessing bonds and traditional active strategies are typically concentrated and volatile. We believe you either must accept “index minus” outcomes or manager selection risks.   

We think there is a better way: a systematic investment approach seeking advantages of both passive and fundamental active strategies, while controlling their shortcomings.

Figure 1: A systematic approach may be the best way to achieve high yield returns with low tracking error¹

Passive high yield strategies deliver “index-minus” results

The most commonly used high yield ETFs (with almost $25bn in consolidated net assets²), the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the SPDR Bloomberg High Yield Bond ETF (JNK), have consistently underperformed their benchmarks and the broad US high yield market, as represented by the Bloomberg US Corporate High Yield Index (Figure 2).

Figure 2: US High yield ETF investors have experienced persistent underperformance²

Liquidity is a major hurdle

Poor liquidity, wide bid/ask costs and costly manager fees in high yield (a consequence of post-2008 era banking regulations) have been major factors for this widespread underperformance. The ETFs in Figure 2 even track “liquid” high yield indices and as a result sacrifice illiquidity premia from the smallest, least accessible issuers.

Additionally, fundamental active managers typically suffer concentration risks due to resource constraints. They often rely on credit analysts to deliver alpha, but even the most well-resourced team could never attempt to fully cover the ~880 unique issuers in the high yield index. The result is relatively concentrated active portfolios. We find 75% of fundamental active high yield managers hold fewer than ~400 bonds (~20% of the Bloomberg US High Yield Corporate Index)³.

But there is a potential solution

We believe “credit portfolio trading” is a solution to the liquidity problem.

We pioneered this trading protocol in 2012 by exploiting liquidity within the ETF ecosystem. We find we can reduce high yield transaction costs from 60bp-80bp (for traditional over-the-counter trading) to 10bp-20bp, even for thinly-traded bonds (essentially earning a free illiquidity premium).

This involves trading ‘baskets’ of bonds. We find we can transact $500m of bonds in a single day, cutting execution times to hours, rather than days or weeks. In our view this is essential when dealing with fleeting value in hard-to-access bonds. 

Reducing trading costs can go a long way to matching the benchmark, but fully meeting it requires enough alpha to offset remaining trading costs. We believe a systematic approach can consistently help to achieve this.

How does a systematic fixed income approach work?

Systematic approaches make use of structured data, quant research and computing power for alpha positioning.

Our proprietary models aim to identify fundamental value and mispricing opportunities, allowing us to tilt portfolios towards the most attractively priced bonds, and away from bonds where expected returns do not justify the risks. A well-calibrated model can analyze a whole bond universe, quickly and repeatedly. This is a huge advantage in a market with thousands of bonds – where a traditional active manager is limited by credit analyst coverage and research time.   

As such, we can build portfolios with numerous active “micro positions,” rather than the large, concentrated positions common in most traditional fundamental active strategies. We also target often-fleeting alpha opportunities in less liquid bonds.

A systematic strategy is likely to create a uniquely-structured portfolio. Our strategy, for example, had an alpha correlation of less than 0.25 with 90% of the fundamental active high yield manager universe, and had a negative correlation with 60% of it⁴.

Systematic approaches are innovative, but not new

Key to our approach is integrating portfolio management, research, and trading disciplines within a single team to challenge conventional thinking. This helped us develop our proprietary trading protocols and our systematic approach.

Our high yield strategy has a decade-plus track record of aiming to match the broad high yield index net of costs and charges.

We believe now is the time for investors to optimize their high yield allocations. A systematic approach could be the answer.