Better trading improves investment performance for high yielding assets

Published on 31 March 2021

Higher yielding assets – from a true yield perspective covering BBB credit to certain emerging market assets – are proving highly attractive at present and there are parts of those markets where investors need to be very cognisant of liquidity issues. Risk transfer can be more difficult as dealer often hold less balance sheet for this part of the market.

There has been a significant growth in the use of single name credit default swaps (CDS) and exchange traded funds both defensively and aggressively in high yield but inexperienced investment managers may not see the risk in the market, particularly with limits to Federal Reserve intervention, notes Scott Kimball, co-head of US fixed income at BMO Global Asset Management.

David Parker, head of MTS Markets International, highlights the advantages that electronification of the market can bring, and together they discuss how better trading can support returns for high yielding portfolios.

Dan Barnes Welcome to Trader TV – your insights into trading for professional investors, I’m Dan Barnes. Joining me today are David Parker, head of MTS Markets International, and Scott Kimball, co-head of US fixed income at BMO Global Asset Management. We’re going to be looking at the way that trading impacts the returns you can get from high yielding investments.

David, Scott, welcome to the show.

David Parker Thanks, Dan, great to be here.

Scott Kimball Thank you for having me.

Dan Barnes How would you characterize the liquidity, risk and returns that we typically see for high yielding assets compared to investment grade and rates markets?

Scott Kimball We’ve seen over the last 12 months, some very unusual and historically significant interventions into the credit markets, primarily the Federal Reserve expanding their balance sheet options to include investment grade credit and the entry point of high yield. This has a cascading effect on liquidity across the system. We’ve seen that even a crisis period, a significant amount of investment grade issuance from companies that were under duress in retail fx were able to come to market. And as a result of that investors returned in full force. They felt the strong support from the Fed, almost a backstop, if you will, to credit market liquidity. And this resulted in a tremendous amount of liquidity coming into the high yield market, even across the riskier parts of fixed income. While this is supported of late and it feels real and permanent, we do think that when there is a risk off market, there is a possibility of some resetting of liquidity parameters. You start seeing high yield trade a little bit more like high yield wider being asked, more volatility, and in some cases difficulty even moving certain parts of the market.

Dan Barnes When we talk about high yielding assets, there is, of course, high yield credit. Should we consider other asset classes as well, potentially EM, given that they have high yields? David, do you want to talk about perhaps how we think of high yielding assets?

David Parker Traditionally high yield would be something rated BBB minus or lower. But in this market where, as Scott said, there’s been a lot of liquidity that’s been forced into it and assets have been tightening. You know, maybe we could look at it from the true yield perspective, which I would say the high yield market is roughly around 4% percent yielding. And then you mentioned emerging markets. So it opens up that whole space as something we could consider almost a part of high yield, in that it shares higher yielding characteristics, obviously risk and also the specialty market.

Dan Barnes What are the trading challenges that we might associate with high yielding assets?

Scott Kimball One of the biggest challenges is that the market has really bifurcated into two buckets, things that don’t yield very much and things that yield more. And because of that, there’s been this liquidity contagion where the liquidity of German bunds, even at negative interest rates relative to positive yields in treasuries, looks remarkably similar. Or if we jump over to high yield, we expect to see a little bit more differentiation. And in some cases we do. So, for instance, if you look at parts of the esoteric CMBS market down in structure, BBB-rated or below parts of the CMBS structure, things that are really exposed to principal loss; there liquidity is a challenge. We see these markets in 1 or 2 point bid-ask spreads.

Yes, there’s been a lot of recovery, but the amount of time required to find buyers is still elongated, so there are parts of the market where you have to be very cognizant of your trading relationships, and also be very intentional about valuations and understanding where you think value lies, because the market can be way ahead of you or way behind you. In some cases, it’s an opportunity, in others it’s a significant headwind. It feels like if you’re only focusing on the big, high yield issuers, that the market is very liquid. And it is, but as you start dipping into some of these other sectors that you mentioned, there’s some more traditional bargaining power that buyers and sellers have depending on the day.

David Parker Broadly, in the high yield space, risk transfer can be a lot more difficult because dealers don’t maintain as much balance sheet risk for that space. And therefore, it’s very important, more so than most other markets, to find a buyer for every seller, or a seller for every buyer. That’s where electronic trading can be beneficial, in particular for the less active names and the smaller players in the space.

Dan Barnes Presumably, it also means that you perhaps need to think about how you’re going to trade a lot more pre-trade?

David Parker Absolutely. You need to know not only who is trading a given bond or a given space, who’s good at it, but also where has liquidity been in terms of the price itself, the bid offer, and even better may be how many bids and offers there have been historically on a bond or a name over time, for extra points, same data in disruptive, market scenarios. So we all know that when the market really gets volatile, liquidity is going to accrue to the largest issues. What happens to your portfolio in that environment and what happened last time?

Dan Barnes So Scott, with that in mind, does that affect the type of instruments you might use to manage a portfolio, fx using derivatives or exchange traded funds?

Scott Kimball There’s been a tremendous amount of growth in the use of derivatives, particularly in high yield, single name CDS, and also the growth in the ETF market. These are excellent tools to get portfolio proxies for both when you’re funding a portfolio, or if you want to be opportunistic. But also on the defense side, the one thing that we would caution about liquidity in this environment versus past cycles; even in investment grade, we see there’s some single name CDS contracts that only trade once per day or once per week. In high yield there’s not quite as robust of a universe, but there’s even more instances of single name CDS that doesn’t trade quite as much.

But index level CDS that gets you hedging the market factor risk is probably the better risk management tool, if what you’re focused on is getting a proxy for defending your high yield portfolio against broad market concerns. That being said, our biggest caution in all of this is; you saw it a lot last March and we’re coming up on a one-year anniversary of some of that market turmoil. There’s a lot of people trading these instruments who haven’t necessarily seen that type of market volatility before, a lot of new entrants into the space, a lot of third party platforms. And I think some of them are kind of ingrained to think that this Fed intervention is just sort of a freebie, that occurs. There’s no guarantee of that in the future. That balance sheet is looking pretty large.

Dan Barnes How does electronification potentially help with finding liquidity or price formation?

David Parker Electronification really helps the data dissemination and then collection, i.e., where has this bond been? How much liquidity has there been on it? Number two, where can I find point in time liquidity? And then number three, in high yield and other liquid paper, how can I, as an asset manager, reach others who want to take the opposite position?

Scott Kimball If you’re investing a cash flow into a portfolio, whether you’re a traditional asset manager or an ETF, it makes things a lot easier on all of us when, if we have to buy three to five million of the bond that’s been issued a year ago and it’s now off the run, to be able to send that out to the market and reach not just the sell-side itself, but people in the buy-side who are looking to maybe find a liquid spot for that security; that connectivity is essentially important. And as it expands into places like emerging market debt, both hard currency and local, it can only be better.

David Parker There are new players that are moving into the credit space and high yield, whether they’re ETF trading firms or coming from some other part of the market. And I think one of the biggest value ads for electronic trading is that it provides those new entrants and others that might want to get involved, with a data set to make them comfortable about where things are happening to trade and where the market is.

Dan Barnes Do you see that effective trading for high yielding assets can potentially deliver better investment returns?

Scott Kimball There’s no question about that. I think on the one hand, earning a liquidity premium, for example, if you’re running a multi-sector or a strategic income strategy, where you can earn a premium by being a provider of liquidity, that’s a sound investment strategy for longterm buy and hold. But there’s no question that the market these days, you know, there’s a lot of retail money, a lot of asset allocation money from 401k and individual investors. And those investors need to be able to shift their portfolios to be optimized for their own risk return profiles, but also for institutions, better liquidity, better portfolio results. There’s a very strong correlation there and it’s ultimately better for investors.

Dan Barnes Scott, David, that’s been really good. Thank you so much.

Scott Kimball Thank you for having me.

David Parker Thanks, Dan.

Dan Barnes I’d like to thank David and Scott for their insights today, and, of course, you for watching. To catch up on our other episodes, go to TRADERTV.NET.