Bond ETF’s – Don’t Ignore the Trees for the Forest of Bonds

Some Bond Specific Reasons to be Careful in HY ETF’s

There are many parts of the HY market that will do well to just return coupon in the near term. I don’t want to pick on indices or ETF’s, but let’s do it.

Let’s take a look at some of the top 10 holdings in the index JNK is meant to match (we will ignore for now that JNK seems to track HYG better than its index since that is another story). These bonds are also big in HYG.

The single largest bond is Sprint/Nextel 9’s of 2018. Not a bad bond, but at a dollar price of 120, some investors won’t want to purchase it. Even treasury investors tend to demand a small discount for such high $ prices. At 5.16% yield, there is a decent amount of rate risk. If the 5 year treasury backs up 50 bps as part of any “risk on” trade, the credit will have to tighten by 50 bps just to tread water. If you think we can get more spread tightening in a risk on rally without treasuries backing up, I would highly disagree.

The 5 year treasury was at 1.2% just in march, and is currently at 0.69% for a 50 bp move is pretty reasonable. The 5 year traded at 2.2% in June 2011, prior to the real panic in European markets. If the ECB is successful in stabilizing rates, it doesn’t seem unthinkable to see the 5 year back to those levels. It probably won’t get that far because of Fed language and Operation Twist, but I also don’t see Sprint tightening the 150 bps to keep pace if it does happen.

So Sprint has high dollar price and a low yield. Hard to get big performance from that bond at this price/yield.

The next bond is HCA 6.5% of 2022. At a price of 111 these are at 4.72%. Running this bond without a treasury hedge seems like suicide to me. It is very easy for me to see good company performance get outpaced by weakness in treasuries in any rally scenario. In the downturn scenario, the bonds could do okay for awhile based on rates, but eventually spreads would widen too.

There are many similar bonds out there with similar characteristics, which is why near term, I can see spread products (like CDS or rate hedged bonds) outperforming straight HY (which is certainly how the ETF’s own them).

The First Data 12.625% bonds are somewhat better from a potential return profile (though I don’t have an opinion on the credit). At a price of 103.38, at least these bonds still have some upside, as the calls aren’t much into play. I get that the YTM is 11.96% and YTC is 11.91% (the I-shares website has YTM = YTC for this bond at that price, which strikes me as a mistake). This bond could still go a lot higher without being held back much by the calls (not a credit decision, just a look at yields).

The Caesar’s 11.25’s are another big holding in both ETF’s (and the index). At a 108.48 price I get these bonds to have a YTM of 8.99% and a YTC of only 6.63% (again, the I-shares site has YTC=YTM which is clearly wrong). So these bonds are trading to the 105.625% call in June 2013. How high are these bonds going? If all goes well, you might get a small pop. On the other hand, Caesar’s is in HY18. In fact it is the widest name. Yes, lots of issues with the 11.25’s being first lien and CDS not, with 5 years versus 1 year potential call, but, if things get better, you don’t get paid much to own the 11.25’s.

Credit Selection AND Asset Selection are BOTH Important

Credit selection is key, but so is asset selection. Which bond, hedged or unhedged, or even CDS will influence returns as much, if not more than specific credit selection. I am not trying to downplay specific credit selection, especially as we move into an environment that investors need to move down into the sketchy end of the credit spectrum to get any return, but I do believe the way you place your credit bets can mean as much in the long run.