Navigating Opportunities in Senior Loan and High Yield Corporate Bond ETFs

Investors needing to generate income in today’s low interest rate environment are faced with distinct challenges in seeking to meet their return objectives, while balancing the risks to which they are exposed. This situation is complicated by the tendency for investors to focus on certain risks, while ignoring others. Case in point: many bond investors have been conditioned to focus primarily on credit risk—the risk that a bond issuer will fail to repay its debt with interest—while failing to consider how an increase in interest rates may cause a significant decline in the value of bonds that were assumed to be relatively “safe” (see chart below). This concept is particularly challenging for the present generation of investors whose experience over the past 30+ years has been in the context of a secular bull market for bonds, in which yields have consistently trended lower while bond prices have trended higher.

In this newsletter, we will consider how senior loan and high yield corporate bond ETFs may be utilized by investors to pursue a higher level of income while seeking to mitigate the impact of rising interest rates. We’ll discuss why we believe benchmark indices are flawed investment strategies for gaining exposure to these asset classes, and we’ll highlight how First Trust utilizes active management to seek better risk-adjusted returns than passive senior loan and high yield corporate bond index ETFs.

The case for senior loan and high yield ETFs

Perhaps the most attractive attribute of high yield bonds and senior loans is the relatively high level of income offered by these securities compared to investment grade bonds. While the current low interest rate environment has made it increasingly difficult for investors to reinvest capital from recently matured (or called) bonds at interest rates adequate to meet return objectives, the S&P/LSTA Leveraged Loan Index and the Barclays US Intermediate High Yield Corporate Bond Index have yields of 5.1% and 5.6%, respectively, compared to the 2.4% yield for the Barclays US Investment Grade Corporate Bond, 5-7 Year Index (as of 3/31/13). Additionally, senior loans and high yield corporate bonds may provide diversification benefits to fixed income portfolios due to the relatively low, and even negative, correlations between these asset classes and investment grade corporate bonds and US Treasuries (see matrix below).

The low correlations between these asset classes are largely due to differences in their respective sensitivity to changes in interest rates and credit conditions. On the one hand, US Treasuries and investment grade corporate bonds are both highly sensitive to interest rate changes but less sensitive to credit conditions; on the other hand, senior loans and high yield corporate bonds tend to be quite sensitive to changes in credit conditions, but less sensitive to interest rate changes.

This has important implications as the US economy continues to strengthen, which will likely lead to rising interest rates in the future, resulting in falling bond prices. For example, following simple bond arithmetic, a hypothetical 1% increase in interest rates would result in an estimated 5.1% decline in the value of the Barclays US Investment Grade Corporate Bond, 5-7 Year Index, effectively wiping away 2 years’ worth of interest income (as of 3/31/13, see chart above).

Senior loans tend to carry very little interest rate risk since they are typically structured as floating rate instruments; issuers are obligated to pay an interest rate that is pegged to a floating rate benchmark, notably LIBOR. For senior loan investors, credit risk is a much more important consideration. Prices are positively impacted by improving economic conditions and corporate fundamentals, which typically result in narrowing credit spreads, and negatively impacted by deteriorating conditions, which typically result in widening credit spreads.

Similarly, high yield corporate bonds are quite sensitive to credit conditions, but unlike senior loans, typically pay a fixed interest rate. As such, they are generally more exposed to interest rate risk than senior loans, but less so than investment grade bonds. The latter is due to the fact that interest rate increases often coincide with periods of relatively strong corporate fundamentals, wherein credit spreads are decreasing, thus offsetting some of the negative impact that rising interest rates have on bond prices.

Market cap weighted indices and risk-management

Over the past few years, ETFs have been a popular choice for investors looking to gain exposure to senior loans and high yield corporate bonds, with assets reaching $33.8 billion.2 While the vast majority of these assets are invested in ETFs that track market-cap weighted benchmark indices, we believe this approach is fundamentally flawed.

Our primary complaint lies in the fact that an investor tracking these indices is effectively lending more capital to the most indebted issuers, and less to the least indebted issuers, irrespective of the borrowers’ ability to repay their debts. We believe that such an approach is lacking in terms of risk-management. Moreover, index-based approaches to investing in senior loans and high yield bonds may expose investors to credit risk for which they are not being adequately compensated. For example, from 1920-2011, the average annual default rate for BB and B rated bonds was 1.07% and 3.42%, respectively, while the annual default rate for

CCC rated bonds averaged 13.77% over the same time period.3 This large increase in defaults does not necessarily suggest that investors should avoid CCC rated securities altogether, in our opinion, since these issues may offer relatively high total returns. However, in light of the historical volatility associated with CCC rated credits and their respective default rates, the risk of investing broadly in the lowest-quality category of high yield bonds, without additional credit analysis, typically outweighs the benefits, in our opinion. As of 3/31/13, the two largest high yield bond index ETFs allocated between 11%-12% to CCC or lower rated bonds, and the largest senior loan index ETF allocated more than 16% to CCC rated issues.4

Past performance is not a guarantee of future results and there is no assurance that the mentioned events or improvements will continue.

1Zephyr StyleADVISOR monthly data, 3/31/03-3/31/13

2As of 3/31/13, according to Bloomberg

3Standard & Poor’s

4Standard & Poor’s and Bloomberg

Current default rates may vary from their historical average and there can be no assurance that default rates will not rise in the future.

© First Trust Advisors

www.ftportfolios.com

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