At the end of the day, the main risk that we deal with in high yield investing is default risk. The ability to say “NO” is crucial in credit investing. We have discussed that it is effectively a negative art: what you don’t buy is likely more important than what you do. Buying bonds and loans is simply lending a company money. What bank would lend money to every company that walked in the door with a belief that the law of large numbers would play out? Then why do investors believe that owning 600+ names in a passive high yield fund will protect them?
A goal of the passive ETFs, and indexing in general, is to gain broad exposure to the market while benefiting from “diversification” and lowering risk. The reality is that we actually see greater risk with these strategies. If you were able to do the credit work up front to determine the viability of your investment or have the ability along the way to sell something in which the credit fundamentals deteriorate putting the capital structure in question, wouldn’t that be the better option in managing risk that just relying on the law of large numbers?
A recent example in this arena is the former TXU (now known as Energy Future Holdings and Texas Competitive Electric).1 This company was taken private in 2007 in one of the largest ever LBOs, and issued a massive amount of debt in the process, but it has never been able to grow into its capital structure. After countless out of court distressed debt exchanges, there has been much recent discussion about an official bankruptcy filing in the works. The writing has been on the wall in this name for years, but it is part of the indexes, thus part of the passive products. And given this is one of the larger debt issuers in the high yield space, it weighs more heavily in the indexes and the products that track them. While some of the existing tranches will likely be money good, even in a bankruptcy, we are already seeing huge discounts in other tranches, and the passive products can do nothing but ride the wave down.
If you see a train coming towards you, you’d get out of the way, but here, they can’t. To no fault of their own, but by their mere structure, the passive funds own what fits their policy statement, viable credits or not. It isn’t until after an official default that the credit is generally removed from the index and subsequently from the funds that track the index.2 Because of this, it appears that the passive portfolios have no ability to deal with credit and default risks until after a default has already occurred, which we view as a major hindrance to investing in the high yield market. Rather, in the high yield space, we believe that credit fundamentals must be analyzed to determine an appropriate investment and risk must be actively managed.
1Peritus has not owned, does not own, and is not making any recommendation to own or not to own the security referenced. The information provided herein represents the opinion of the author and is provided for information purposes only.
2In terms of defaults, issuers are not removed from the underlying index until they have been subject to a D rating, which generally occurs after a bond has already defaulted. These issues are removed at the next rebalancing date following the D rating.