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Under The Hood Of SPDR Barclays High Yield Bond ETF

By John Gabriel For strategic, long-term exposure to U.S. high-yield bonds, investors may consider SPDR Barclays High Yield Bond ETF (NYSEARCA: JNK ) as a small core holding. The fund can also serve as a tactical investment for the satellite portion of a diversified portfolio. Investors should bear in mind that high-yield bonds are one of the most volatile sectors of the fixed-income market. Long-term-minded investors looking to JNK as a strategic position are likely to find the diversification benefits of high-yield bonds attractive. High-yield bonds tend to be negatively correlated (or uncorrelated) with government and aggregate bond portfolios, which often make up the bulk of most investors’ fixed-income exposure. Moreover, high-yield bonds are poised to hold up relatively well in the event of rising interest rates and inflation. While rising rates and inflation tend to be the enemy of typical fixed-income securities, the high-yield bond asset class tends to outperform its fixed-income peers during such periods thanks to its stocklike returns and heavier dependence on business fundamentals. Consider that over the past 10 years, U.S. high-yield bonds have shown positive correlation (74%) with the S&P 500, while the Barclays U.S. Aggregate Bond Index has been relatively uncorrelated (26%) over the same period. Remember, interest rates will typically rise when the economy is in good shape and businesses are performing well. High-yield bonds tend to perform well when issuers’ fundamentals are strong or improving (and vice versa). Tactical investors may look to a fund like JNK as a way to bolster income in a yield-starved environment. However, investors should not look at the fund’s yield in isolation. Rather, the current yield should be viewed in relation to the yield offered by U.S. Treasuries with the same maturity. The difference between the two is what is known as the credit spread, and it represents the premium that investors can collect for assuming additional credit risk. The credit spread should also be viewed relative to the expected default rate. According to Moody’s, since 1983 the historical average default rate for high-yield bonds is 4.8%. In the trailing 12-month period through October 2014, the U.S. high-yield default rate was 2.4%, relatively flat from a year ago. Rising default rates typically result in widening credit spreads. But default rates are expected to remain low (around 2%) thanks to favorable credit conditions. Fundamental View The U.S. high-yield bond market has evolved over the past few decades. Whereas in the 1970s the overwhelming majority of high-yield bonds were so-called “fallen angels” (bonds issued by companies that had their credit ratings downgraded from investment-grade to high-yield status), today there is a vibrant and healthy market for new-issue high-yield bonds. According to SIFMA, in 2014, new issuance of high-yield bonds in the United States was $278 billion through October, slightly below the $285 billion sold in 2013 in the same period. By comparison, high-yield issuance averaged $95 billion per year from 1999 to 2009. Many investors may find the significant income potential of U.S. high-yield bonds attractive, particularly in the current low-yield environment. Their income potential is a primary point of appeal that attracts investors to the high-yield corporate-bond market. Indeed, there are very few other investments that offer high- to mid-single-digit yield potential in the current market environment. But other factors to consider include the asset class’ diversification benefits as well as its ability to withstand the impact of rising interest rates, potential inflation, and an uptick in the instance of default. U.S. high-yield bonds offer a favorable risk/reward profile relative to other major asset classes thanks to their equitylike returns with significantly less volatility. Owing to its generous yield, the Bank of America Merrill Lynch High Yield Master II Index (the generally accepted benchmark for the asset class) generated an annualized total return of 7.6% over the past 15 years. This compares to a total return of about 4.6% for the S&P 500. But the BofAML HY Master II Index’s annual standard deviation over that period was 9.9%, compared with 15.3% for the S&P 500. Adding a stake in high-yield bonds to complement aggregate bond exposure can help improve a portfolio’s diversification benefits. In fact, over the past five years, high-yield bonds have been uncorrelated (12%) with the Barclays U.S. Aggregate Bond Index. The asset class’s lack of correlation with investment-grade bonds and its negative correlation with government bonds should be an advantage when we finally see the inevitable rise in interest rates and potentially higher inflation. Of course, these advantages don’t come without risk. This economically sensitive asset class fell more than 32% in 2008 when the markets were roiled by the global credit crisis. Steady inflows from yield-starved investors have helped drive prices higher. The current option-adjusted credit spread between the BofAML HY Master II Index and U.S. Treasuries is about 4.4%. For some context, consider that the long-term average credit spread is about 6%. The all-time low of around 2.5% occurred in June 2007, while the all-time high occurred in December 2008 at the height of the credit crisis when the spread briefly spiked up to more than 20%. Fitch expects U.S. high-yield default rates will remain low through 2015 thanks to accommodative funding conditions and a recovering economy. Moreover, many of the highest risk issuers have taken advantage of favorable credit markets in recent years to extend their lifelines. Portfolio Construction This fund seeks to provide investment results that, before fees and expenses, correspond generally to the price and yield performance of the Barclays Capital High Yield Very Liquid Index. The index includes publicly issued U.S. dollar-denominated, non-investment-grade, fixed-rate, taxable corporate bonds that have a remaining maturity of at least one year. The fund uses a representative sampling strategy to track the index and currently has nearly 800 holdings. Its sector exposure is extremely concentrated, as industrials make up 89% of the portfolio. The financials sector makes up roughly 8%, while utilities round out the portfolio at about 4% of the benchmark. Issues rated BB and B make up 40% and 43% of the index, respectively. The remaining 17% is made up of issues rated CCC or lower. Currently, the fund’s modified adjusted duration is 4.38 years, and its weighted average yield to maturity is 6.39%. Fees This fund charges an expense ratio of 0.40% per annum. While this is quite a bit higher than those levied by funds tracking an aggregate bond index, it is cheap compared with actively managed funds in the same category. High-yield bonds tend to be more illiquid than investment-grade corporate bonds, which can make them comparatively expensive to trade. With an estimated holding cost of 0.72%, JNK reflects the challenges of employing a sampling strategy to track a relatively illiquid benchmark. Transaction costs explain the difference between the fund’s expense ratio and its estimated holding cost. Alternatives The closest alternative to JNK is iShares iBoxx $ High Yield Corporate Bond (NYSEARCA: HYG ) , which has a slightly higher expense ratio of 0.50% but a lower estimated holding cost of just 0.18%. HYG tracks the Markit iBoxx USD Liquid High Yield Index and also employs a representative sampling strategy. It currently has nearly 900 holdings and is much more diversified than JNK in terms of sector exposure. At 4.12 years, it has a slightly shorter duration than JNK. It also has a lower average yield to maturity of 5.59%. Another alternative for investors to consider is PowerShares Fundamental High Yield Corporate Bond ETF (NYSEARCA: PHB ) , which charges a 0.50% expense ratio. PHB seeks to outperform its cap-weighted peers by tracking a fundamental index developed by Research Affiliates, LLC. Investors concerned about the health of the economy and future default rates may favor PowerShares’ PHB, as its benchmark avoids the riskiest issuers (excludes issues rated below B). PHB has a comparable duration of 4.37 years, and its higher-quality portfolio offers a slightly lower yield to maturity of 5.05%. Investors concerned about the impact of rising interest rates may consider SPDR Barclays Short Term High Yield Bond ETF (NYSEARCA: SJNK ) or PIMCO 0-5 Year High Yield Corporate Bond ETF (NYSEARCA: HYS ) , which charge expense ratios of 0.40% and 0.55%, respectively. SJNK currently has a modified duration of 2.4 years, and its yield to maturity is 6.41%. HYS has a slightly lower duration of 1.96 years and currently offers an estimated yield to maturity of 5.47%. Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Putting Together Quant Portfolios

One of the more overlooked areas of quantitative investing is how to integrate quant strategies into a diversified portfolio. Let’s look at a few of the issues involved and some possible solutions. I’ve discussed the big allocation decision already, i.e. how much to put into quant strategies vs. bonds already. I think this decision should be primarily driven by how much risk one is willing to take. I use maximum portfolio drawdown as the primary metric to judge how much risk I’m willing to take. Here is the max drawdown table from that post. For example, to limit annual drawdowns to less than 10% and 30% quant portfolio 70% bond portfolio would be the appropriate allocation. If a 15% max DD is more suited to your risk tolerance then you can go up to a 70% quant portfolio 30% bond portfolio allocation. Of course, this is dependent on the type of quant strategies used but surprisingly it doesn’t matter as much as you may think. The XLP/XLU quant strategy is one of the most conservative strategies while TV is one of the most aggressive and best performing, yet in terms of max DD there is not that big a difference. OK, now for some of the subtle details of building quant portfolios. First, why pick more than one quant strategy? Shouldn’t you just pick the best one with respect to whatever metric you want? I would argue no, mainly due to behavioral factors. Investors have a hard time with underperformance, no matter what the long term track record of a strategy may be. Let’s take this year as an example and compare one of the best performing quant strategies over time, a value and momentum microcap stock quant portfolio, to a conservative utility value strategy. The micro cap quant strategy has returned over 22% a year since the late 60s as compared to 16% a year for the utility value strategy. In 2014, the micro cap strategy is up 3% while the utility strategy is up over 29%! That kind of divergence is hard to swallow for most investors and leads to performance chasing. The best way to avoid this is to choose multiple strategies and choose strategies with high base rates . At the simplest level using more strategies increases the odds that at least one is outperforming and thus lessens the odds of making behavioral mistakes. OK, now that we’re going to choose multiple quant strategies, we need to avoid a few pitfalls. The two big ones for me are over-diversification and excessive fees. The quant strategies I’ve presented on the blog usually have 25 individual stocks in a portfolio. If you’re going to go with 3 quant strategies then we’re talking about 75 individual stocks. Besides paying way more in fees by holding too many stocks we reduce the power of the quant strategies. Two great post on this subject are, Avoid Diworsification , and You need to Dare to be Great . Here is the money pic. (click to enlarge) 10-15 individual stocks gives about the best bang for the buck for any one of the individual quant systems. So let’s say we go a bit crazy and choose 5 different quant systems that we’d like in our overall portfolio. We’ll choose the TV2 systems, the EDY system, the Large stock SHY system, the XLP system, and the XLU system. I’ve posted all of these systems before. See here for a list of all my quant posts. 10 stocks each. Yearly holding period and go back as far as we can, Dec 2008, for the P123 book simulation tool that I use. I’ll call this the Quant 5. Results of the overall quant portfolio are below. (click to enlarge) Pretty impressive results. Over the full period, all of the quant systems beat the market handily. But there have been significant periods of underperformance for several of the systems. For example, over the last 3 years, the EDY systems and the XLU system have underperformed the market and the other systems. The top quant system over the full period from 2008 turned out to be the large stock SHY system even though going back further to 1999, other systems have performed better. Of course, how could you know that before hand? You can’t. Bottom line: It pays to diversify, but not too much. Not just in terms of risk adjusted returns but probably more importantly in terms of an investor being able to stick with quant investing over the long term.

Should I Have High Yield (Junk) Bonds In My Portfolio?

Summary By buying junk bonds I would take on more risk. The trade off is I would expect better returns. Do high yield junk bonds belong in my portfolio? Junk Bond Risks Companies that have low credit ratings pay higher interest rates, but of course those rates come with higher risk of default. Below we show data from Fitch that shows historical default rates. Non-investment grade (junk) rating consists of data rated BB and below. As can be seen default rates rise quickly as rating grades get worse. Fitch Global Corporate Finance Average Cumulative Default Rates: 1990-2013 1 year 2 year 3 year 4 year 5 year 10 year AAA 0 0 0 0 0 0 AA 0.03 0.03 0.07 0.13 0.19 0.24 A 0.08 0.22 0.38 0.52 0.71 1.82 BBB 0.19 0.66 1.19 1.76 2.36 4.64 BB 1.09 2.68 4.27 5.71 6.95 10.94 B 1.94 4.54 6.87 9.01 10.88 11.44 CCC to C 23.51 31.48 34.96 37.01 39.58 39.54 Investment Grade 0.11 0.35 0.61 0.88 1.17 2.27 Speculative Grade 2.88 5.33 7.38 9.16 10.70 13.38 All Corporate Finance .73 1.43 2.04 2.59 3.07 4.07 It is wise to keep in mind that during severe market corrections ratings tend to get downgraded and default rates increase. Fitch-Rated Global Corporate Finance Issuer Default Rates Default Rates 1990-2013 Year Default Rate (%) 1990 1.36 1991 2.25 1992 0.65 1993 0.00 1994 0.00 1995 0.11 1996 0.29 1997 0.08 1998 0.42 1999 0.85 2000 0.38 2001 0.90 2002 2.17 2003 1.16 2004 0.12 2005 0.32 2006 0.07 2007 0.10 2008 1.28 2009 2.58 2010 0.49 2011 0.30 2012 0.65 2013 0.51 As we can see above during both the Tech Wreck and the Great Recession defaults increased substantially. Junk Bond Returns compared to 5 Year Treasuries Portfolio Visualizer provides some excellent tools for backtesting. I used their tools to generate a backtest for comparing High Yield Bonds to 5 Year Treasuries. Portfolio 1 – High Yield Bonds – As represented by Vanguard High Yield Corporate (MUTF: VWEHX ) Portfolio 2 – Five Year Treasuries (click to enlarge) (click to enlarge) As shown about High Yield bonds did return slightly more, but had a much larger maximum drawdown and worse risk adjusted returns based on the Sharpe Ratio and the Sortino Ratio. (click to enlarge) The year -by- year comparison shows that treasuries performed well when the equity market was correcting while High Yield bonds performed poorly. Conclusions Junk Bonds had a slightly higher CAGR over the 1990-2013 time frame, but the advantage was small 7.11% to 6.59% and Junk Bonds actually trailed the treasuries from 1990-2011. Was the small advantage in CAGR worth the risk? The maximum drawdown for the junk bonds was -21.29% the max drawdown for the Treasuries was -4.33%. Junk bonds had a Sharp Ratios of 0.41 and Sortino Ratio of 0.75 compared to a Sharpe Ratio of 0.59 and a Sortino Ratio of 1.40 for the treasuries. I’m semi-retired and bonds are the low-risk part of my portfolio. The possibility of a 20% plus drawdown in the ‘safe’ part of my portfolio makes be lean toward selecting the treasuries. When you add in the fact that the high-yield bonds barely beat the treasuries in total returns it’s a no-brainer. Not only did junk bonds have larger drawdowns they had them at the worst possible time. When equities were taking a beating in 2008 High Yield bonds were going right down with them: -21.29%. Treasuries were up 13.32% in 2008; this is exactly the kind of negative correlation I want my bond holding to display during an equity market correction. Junk bonds have taken a hit lately and the spread between high yield and investment grade bonds has widened. Some investors may view this as an opportunity. I still do not view the risk/reward favorably. If I need higher returns I would be inclined to add more equities and keep my bond investments in Treasuries or investment grade corporate bonds. Bonds are in my portfolio to provide safety, smoothing out my returns and keeping me from having to sell losing investments during a correction. Junk Bonds don’t fit the bill. I won’t be adding junk to my portfolio. I am not a professional advisor or researcher. I am an individual investor who studies investing and shares my thoughts. I encourage all investors to do their own due diligence and please share your findings. I strongly feel the best thing about Seeking Alpha is the sharing of ideas. Please comment; I value your input. Divergent opinions are welcome.