The iShares iBoxx $ High Yield Corporate Bond ETF (ticker: HYG) is the largest U.S. High Yield ETF in terms of AUM, with more than $14 billion of assets as of 11/17/14. The management fee for HYG is 50bps annually. Is this cheap? Is it expensive? We believe that two questions are imperative in forming a conclusion:
- What are the options for expressing your view in high yield?
- Where do you fall in the strategic-tactical continuum? Expressed in another way, how often do you plan on turning over your high yield position?
In his recent post, What’s luck got to do with it?, Adam Grimes demonstrated the importance of considering randomness in performance evaluation. The results, for some, may be quite shocking: with 50 hypothetical traders each taking 250 trades from the same, positive-expectancy trading system, you have results ranging from -40% to +100% returns. For those familiar with random walks, this is less surprising. Positive expectancy is great, but variance, it turns out, can be a bitch.
It’s a point we’ve touched upon before, but in a different light. In particular, we’ve discussed how the choice of when to rebalance (which is akin to “sampling” from a trading system) can dramatically affect performance results.
I read another blog post recently from Cesar Alvarez over at Alvarez Quant Trading on a Heikin-Ashi chart-based strategy. The strategy design was fairly straight forward: using monthly Heikin-Ashi bars, go long after a positive month and exit the market after a negative month. Ideally the composition of the Heikin-Ashi bar itself would help filter out a significant amount of whipsaw noise.
In our last post, we discussed preferred stocks and how they are a hybrid security with both bond-like an equity-like characteristics. In today’s post, I will go into a bit of detail on another type of hybrid security, convertible bonds.
What are Convertible Bonds?
On the most basic level, convertible bonds are corporate bonds that can be converted into shares of equity in the issuing company, with the conversion ratio and price set when the bonds are issued. Like bonds, they pay coupons and will return the face value upon maturity, assuming that they have not been converted to stock and that the company has not defaulted. Their value will also be affected by changing interest rates and credit spreads.
Preferred stocks are hybrid securities that contain features of both bonds and equities. Like bonds, they pay dividends according to a rule, usually a rate set at issuance but occasionally a floating rate (e.g. LIBOR + spread), are rated by credit rating agencies, and are affected by changes in interest rates. Like equities, they have the potential for capital appreciation, although less than common stock, and receive favorable tax treatment on their dividends. Additionally, in the case of a company’s bankruptcy, preferred security owners’ claim on the liquidation is higher than common stockholders but lower than bondholders. These features make preferreds different enough from standard equity and bond holdings to play a unique, valuable role in a portfolio.
The prolonged low yield market over the past six years has forced many investors to search for nontraditional ways to generate income in their portfolios. Traditionally, dividend stocks, Treasuries, corporate bonds, and high yield bonds have been the standbys, fulfilling this role faithfully for decades. However, the low interest rates maintained by the Federal Reserve and shrinking credit spreads have reduced the attractiveness of these assets, especially as rates are poised to begin climbing. With the 10-year Treasury rate at ~2.6% and dividend yield on the S&P 500 at ~1.8% (compared to their 30 year averages of 5.7% and 2.35%, respectively)1, investors are shying away from low-yielding, duration heavy traditional income producing assets and flocking to higher yielding alternatives.
(Note: see our previous post on Bank Loans for an explanation of that alternative)