Today brought news from ETF Stream of two exciting new ETFs about to hit the European stock markets, one in the ‘oh-so-sexy’ cryptocurrencies space, the other in the staider world of high yield credit.
The hot news is that Swedish ETN provider XBT is listing a new ethererum tracking note in Stockholm (COINETH). Being an ETN not an ETF, COINETH is unsecured debt tracking the spot price of ethereum. Ethereum “is a cryptocurrency that trades on a blockchain, just like bitcoin. Many people believe that ethereum is better than bitcoin because its blockchain has an additional feature called the ‘smart contract’. The ‘smart contract’ allows ethereum to not only track transactions but programme them. ‘Smart contracts’ let investors exchange other assets – such as shares or property – without having to go to a lawyer, accountant or third-party service provider. Despite arguably holding more promise, ethereum has been more volatile than bitcoin. During a flash crash in June, it sank from $319 to 10 cents in seconds. “
I was initially desperate to say that I wouldn’t be racing out to buy this ETN but – sticking with my religious imagery – a horney little devil on my shoulder has got me tempted. For the record, I can’t imagine buying anything more than a tiny amount but this ETN is a first. Most crypto heads that I talk to highly rate Ethererum as a more adaptable and flexible digital currency – which could, of course, be its vulnerability!
Perhaps more importantly though I can see this ETN proving hugely popular with slightly cynical types like me who fundamentally don’t understand the space but aren’t entirely be willing to be left out. Crucially as asset allocation cash comes into the space – from these older, more cynical investors looking at ETNs – we might see a liquidity squeeze which might help push values for the digital currency higher. In sum, a classic tulip inspired pyramid scheme.
The much more respectable option comes in the shape of a new PowerShares listing which tracks “fallen angels”—the PowerShares US High Yield Fallen Angels UCITS ETF (FAGB, FAEU). The index tracks American and Canadian companies that had their bonds downgraded anytime the past five years.
The idea of investing in the bonds of these fallen angels has been kicking around for many years stateside. It refers to bonds that were originally issued as investment grade corporates but have subsequently been downgraded to non-investment grade (high yield) bond status.
Fallen angel issuers tend to be larger companies such as ArcelorMittal, JC Penney, Dell, Sprint and Nokia. According to Van Eck – an ETF issuer in the US, but now part of Invesco – relative to the broad high yield bond market, fallen angel bonds have historically averaged higher credit quality, higher absolute returns and higher risk-adjusted returns. In one US fallen angel index, BB rated paper accounts for 77% of holdings as opposed to 47% for most ordinary high yield indices.
BofAML, for instance, has both a high yield and a fallen angel index – the fallen angel index has a current yield to worst of 4.3% versus its bigger sibling at 5.68%. Modified duration is longer (6.51 vs 4.84) but the fallen angel version has just 238 bonds versus 1888 bonds for the bigger sibling. Crucially for this BoAML index series, Fallen Angels have outperformed the High Yield version for all but two of the last 12 years since 2004.
For wider background Citywire’s Nisha Long earlier this year penned an excellent overview for the Selector service: you can see the longer article here http://citywireselector.com/news/fallen-angels-rise-again-a-bond-sector-case-study/a1019621
Over the last three years, the BofA Merrill Lynch US Fallen Angel High Yield TR index has almost doubled the returns provided by the traditional high yield market.
On top of this, the performance would have come with less risk level than conventional high yield. What is more surprising is that returns were close to the S&P 500 equity index, however, the volatility of returns was a lot higher.
The positive performance of fallen angels is more pronounced over the past year where the index posted higher returns than both US high yield market and US large-cap equity markets. In addition, it took less risk than the S&P 500, and the riskier end of the US high yield market.
Some of this performance can be attributed to fallen angels’ higher maturities, lower coupons and higher duration compared with original-issue high yield. Interest rates have fallen significantly over the past few years, which accounts for some of the outperformance.
What’s powering these impressive returns from Fallen Angels?
Dig into the literature and behavioural economics rapidly emerges as the prime driver, along with the incredibly conservative nature of some in-house fixed income investment policies. Many large institutions investing for the long term typically tend to avoid having anything more than a notional exposure to riskier sub-investment grade bonds – their investment policies explicitly prohibit them in many cases from taking on too much risk.
Thus, when a once investment grade business starts to “wobble”, many of these more conservative investors tend to bail out very quickly. The inevitable credit agency downgrade frequently results in a rush for the exit, and an undershoot in terms of the share price.
But if the fallen angel manages to survive we begin to see a curious phoenix-like rehabilitation occur – investors have assumed the very worst, but in their rush to ‘judge’ they’ve ignored the corporate restructuring that has resulted in a robust return to profitability. There’s also some limited evidence that default rates amongst these fallen angels is actually lower than many comparable, ‘native high yield issuers – arguably the core business is still strong and the subsequent restructuring has made the business much more robust through the business cycle.
The last obvious question is why now? With many analysts warning of a rise in corporate defaults in the high yield space, aren’t Fallen Angels the very worst place to be looking at the business cycle? Only a few weeks ago European analysts at investment bank Morgan Stanley observed that “in the last 6 months there has been a 74% increase in the amount of high-yield debt trading at distressed levels. In contrast to two years ago when Energy was far and away the largest driver of the upturn distressed debt, the sector composition of distressed US high yield debt is reasonably broad.” Crucially these analysts also observed that credit quality has also been declining in Europe as well – “the proportion of BBB debt in EUR non-financial IG markets has now reached 59%, a record high, while duration risk has also increased as companies have pushed out the maturity of issuance. Similarly, in the proportion of covenant-lite loans in the European Leverage Loan Index has reached a record high of 67% year-to-date”.
The bulls by contrast point to another, perhaps more prominent set of numbers – all of which suggest that the global economy is actually picking up speed. Those same European analysts at Morgan Stanley one week later featured a report with the headline the “Global economy is booming”. One key signal looked at Korean exports for instance which are growing at a 35% annualised clip. Pieter Jansen, Senior Multi Asset strategist at NN Investment Partners has also talked about this recovery suggesting that “Higher global growth would create an environment in which investors would be tempted to move into equity-like assets. Given that High Yield tends to have the highest positive correlation to equities among the Fixed Income classes, it would likely become a preferred investment class in our first scenario”.
If Jansen and the MS analysts are right, then maybe Fallen Angels are a possible sweet spot for investors hungry for higher-yielding fixed income returns?