The FlexShares Corporate Bond Credit Score

Transcription

1 THE CASE FOR INNOVATION IN CORPORATE BOND INVESTING The FlexShares Corporate Bond Credit Score LKOR SKOR INCOME RISK MANAGEMENT GENERATION Responding to investors needs, we have developed a new approach to evaluating corporate bond investibility. A SYSTEMATIC AND SCALABLE APPROACH TO CREDIT INVESTING Extensive resources are dedicated to innovations in quantitative equity market research, because stocks higher return potential easily justifies the expense and effort. Innovation in the fixed income markets, however, has always lagged equities. Why? Key reasons include: The asymmetrical return profiles of bonds versus equities; Deficiencies in the availability and accessibility of fixed income market/trading data; Muted investor interest (i.e., fixed income lacks the wow factor of other asset classes); and Supply/demand imbalance in the over-the-counter (OTC) trading model. Today, however, several years of global central bank intervention and regulatory change are creating new opportunities for fixed income product innovation even while legacy active and index products remain the preferred choices for bond investors. The tide is starting to turn as both asset managers and investors confront a changed investment landscape. Today s ultra-low interest rates and reduced trading liquidity have become catalysts for fresh product ideas, aided by new sources of bond data, improved quantitative models and growing ETF distribution platforms. Mindful that normalized interest rates and trading activity may never return, fixed income investors increasingly favor new products that: Are economical and efficient; Follow a rules-based strategy; Pursue a systematic approach to investing (e.g., credit evaluation/selection); Elevate transparency in trading/valuation; and, of course, Maximize returns relative to risk. flexshares.com The Case for Innovation in Corporate Bond Investing 1 of 8

2 Across the last several years, the negative impact of quantitative easing on yield and liquidity is becoming clear. Responding to investors needs, we have developed a new approach to evaluating corporate bond investability. Working diligently with experts in quantitative research, credit analysis, portfolio management and index construction, we have applied an innovative credit scoring methodology to develop new corporate indexes that check all five boxes. The FlexShares ETFs that track these indexes represent efficient, passive bond strategies designed for the corporate credit market of today and tomorrow. Here s how the FlexShares team arrived at this new approach to credit investing. Let s look first at the market forces impacting the legacy bond market. THE IMPACT OF QE ON MARKET-WEIGHTED BOND INDEXES The jump in U.S. Treasury and corporate debt issuance since 2008 was induced by the Federal Reserve s quantitative easing (QE) programs. Across the last several years, the negative impact of QE on yield and liquidity is becoming clear. To begin with, let s look at QE s impact on yield. Investors typically expect dramatic shifts in the composition of a market-weighted benchmark to be the result of long-cycle economic considerations. But that was not the case here. Legacy index-based products are constructed using market-weighted exposures and are dominated by the Big 3 sectors: U.S. Treasury, Agency Residential Mortgage-Backed Securities (RMBS) and U.S. corporate debt securities. Exhibit 1 shows the weighting to these sectors as a percentage of the Barclays U.S. Aggregate Index ( AGG ) at various year-ends. Note the sizable shifts out of RMBS and into Treasuries and Corporates after the financial crisis, and how the aggregated Big 3 weightings increased from less than 80% in 2006 to about 88% at mid-year Next, note that the AGG s mid-year 2015 U.S. Treasury exposure reached more than 36% while the corporate credit exposure was nearly 24%. EXHIBIT 1: BARCLAYS US AGGREGATE INDEX SECTOR WEIGHTINGS as of 12/31/ % as of 6/30/ % Treasury Govt. Related Corporate RMBS Other 24.7% 35.0% 14.7% 19.4% 28.1% 36.1% 23.9% 9.3% Source: Barclays Live The combination of these changes, along with falling market rates, have sharply lowered the yield an investor earns when purchasing the bond market. Many participants were dismayed to observe how quantitative easing undermined the predictable attributes of a market-weighted index. This prompted a sizable subset of asset managers to start investigating more purposeful bond indexes and fresh approaches to fixed income investing. flexshares.com The Case for Innovation in Corporate Bond Investing 2 of 8

3 New regulations and decreased profit potential have lowered the level of corporate bond inventories carried by these suppliers of liquidity. BONDS EVERYWHERE, BUT LESS LIQUIDITY TO DRINK Reduced market liquidity for corporate securities increases trading costs and presents greater challenges in portfolio duration positioning and credit risk management. Much like the Ancient Mariner Water, water, everywhere, nor any drop to drink bond market investors today face an environment where the supply of new fixed income securities is abundant, yet market liquidity (the ability to execute timely, economical trades without undue impact on market prices) has deteriorated. Due to the OTC nature of the corporate credit market, broker/dealers are critical for marketmaking, matching buyers and sellers during periods of supply/demand imbalance. In the aftermath of the financial crisis, however, investment banks have reduced or withdrawn from broker/dealer market-making activities. New regulations and decreased profit potential have lowered the level of corporate bond inventories carried by these suppliers of liquidity. This shift is highlighted in Exhibit 2, which shows the decline in average trading volume for investment grade corporate securities as a percentage of corporate debt outstanding. Total corporate issuance has increased at an annual compounded rate of 9.5% from even as average trading volume has declined. EXHIBIT 2: AVG TRADING VOLUME AS PERCENT OF CORPORATE DEBT, % 0.40% 0.35% 0.30% 0.25% 0.20% 0.15% 0.10% 0.05% 0.00% 0.43% % % % % % % % % 2014 Annualized investment grade average daily turnover (volume / outstanding) Source: JP Morgan, FINRA, SIFMA As an example, in 2014, there were nearly 26,000 publicly registered bonds outstanding in the United States, yet, according to Citi Research, 3,000 (11%) of these issues did not trade during the year. Another 20% (5,000 issues) traded on five days or fewer. Only 277, a mere 1%, traded every day. Recent reductions in market liquidity and more onerous trading regulations have added to the burdens of working with this diverse, non-standardized legacy market structure. Data from Citi Research calculates the breakeven timeframe for an institutional investor attempting to rotate $10 million of single bond corporate positions (with a one-year holding period) has increased from an estimated 15 days in 2005 to 85 days in The combination of low interest rates, higher capital costs, wider bid-ask spreads and longer market-weighted index durations have pushed costs higher and yields lower to a point where investors are no longer incented to do many trades. 1 Securities Industry and Financial Markets Association (SIFMA) flexshares.com The Case for Innovation in Corporate Bond Investing 3 of 8

4 The model produces credit evaluations that update with greater frequency and specificity than NRSRO credit ratings when measured against future credit spread and bond price movements. THE PROBLEM WITH AVAILABLE CREDIT RATINGS Credit markets today incorporate new inputs, faster information dissemination, expanded universes of investor types, more diverse investment objectives and many non-traditional product uses. Unfortunately, the evolution of the credit sector of fixed income hasn t kept pace. Many regulatory directives and/or client investment guidelines have been built around Nationally Recognized Statistical Rating Organization (NRSRO) ratings. In fact, credit ratings have gained a seemingly permanent role providing investors with third-party evaluations of a debt issuer s credit standing. However, the years preceding the financial crisis exposed serious shortcomings with NRSRO ratings in practice. For example, a rating of AAA means, an issuer s capacity to meet its financial commitment on an obligation is extremely strong. 2 Yet few in the financial markets believed that AAA ratings given to tranches of subprime mortgage-backed securities were equal to AAA ratings assigned to corporate and sovereign issuers. In the corporate segment, investors discounted strong ratings on highly levered financial firms versus lower-rated industrial or utility companies. Regulatory changes mandated by the Dodd-Frank legislation also have pared back the investment industry s reliance on NRSRO ratings. As evidence: A final rule adopted in September 2015 removed all references to credit ratings from the SEC s regulations governing money funds. This only added to a growing sense among investors that NRSRO ratings haven t kept up with the times. The market is more than ready for a contemporary approach to credit evaluation that integrates smoothly with investor decisions around product application and portfolio design/construction. THE WAY FORWARD: CREDIT SCORING Investors are generally highly informed about the use of algorithms and behavioral tools in the consumer credit space (e.g., FICO scores) and have surely wondered when these advances would make their way to traditional credit analysis. In recent years, equity analytics have developed a wide range of quantitative models that help identify and respond to changing issuer/industry information and shifting macro environments. The challenge was to translate and adapt these techniques and models to fixed income. To that end, the Quantitative Research (QR) group at Northern Trust Asset Management and FlexShares worked together to develop a fully objective credit evaluation process for use in constructing an innovative corporate credit index, one with no reliance on NRSROs. Through adaptation of factor-based analytics, the QR group designed the FlexShares Corporate Bond Credit Scoring Model to evaluate debt issuers based on factors such as management efficiency, profitability and market solvency, which are then sorted and ranked within five macro industry sectors. The model produces credit evaluations that update with greater frequency and specificity than NRSRO credit ratings when measured against future credit spread and bond price movements. 2 Source: Standard & Poor s Ratings Definitions, Global Credit Portal, S&P Capital IQ flexshares.com The Case for Innovation in Corporate Bond Investing 4 of 8

5 The FlexShares Corporate Bond Credit Scoring Model focuses solely on the subset of truly accessible corporate bonds rather than the vast total universe. ADDRESSING THE MARKET LIQUIDITY CHALLENGE... AND MORE Historical trade data indicates that bonds with large amounts of principal outstanding trade more frequently than those with smaller amounts outstanding. So, typically, legacy index providers have tried to improve the tradability of a market-weighted index by increasing the minimum amount of outstanding debt required for inclusion in the index. But considerations other than outstanding debt can make an index more investible and can do a better job of capturing how a bond portfolio is actually built and managed. Achieving this requires incorporating provisions in the index s construction that enhance liquidity. The FlexShares Credit Scoring Model addresses the corporate bond liquidity challenge by optimizing a carefully selected subset of all credit issuers of which illiquid, orphaned and small lot names have been removed. The model also takes into account multiple factors to aid in developing improved corporate bond indexes, including the characteristics of issuers total debt structure, minimum exposure percentages and odd-lot trade restrictions. A SYSTEMATIC APPROACH TO CREDIT INVESTING The market for corporate credit is simply too big and too complicated to be fully investible, and even the most skilled and focused active bond portfolio manager is only able to access a fraction of it. Legacy corporate credit indexes reflect the composition and characteristics of the broad corporate bond market but they fail to provide a readily investible benchmark that serves the needs of investors. The FlexShares Corporate Bond Credit Scoring Model focuses solely on the subset of truly accessible corporate bonds rather than the vast total universe. Applying this model to index fund design resulted in two truly innovative corporate credit ETFs, FlexShares Credit-Scored US Corporate Bond Index Fund (SKOR) (intermediate-maturity corporate bonds) and FlexShares Credit-Scored US Long Corporate Bond Index Fund (LKOR) (longer-maturity corporate bonds). Both offer efficient, economical corporate credit investing in an ETF structure, with all the usual benefits of intra-day market trading, tax efficiency and transparency. Our rules-based credit scoring methodology enables the FlexShares corporate bond index funds to efficiently replicate the legacy credit index s exposures while they match or better returns. FOR MORE INFORMATION To learn more, visit FlexShares.com or call FlexETF ( ). flexshares.com The Case for Innovation in Corporate Bond Investing 5 of 8

6 IMPORTANT INFORMATION Before investing visit flexshares.com/prospectus to obtain a prospectus that includes the investment risk, fees, expenses and other information you should read carefully and consider carefully. Foreside Fund Services, LLC, distributor. Investment in FlexShares Credit-Scored US Corporate Bond Index Fund (SKOR) and FlexShares Credit-Scored US Long Corporate Bond Index Fund (LKOR) is subject to numerous risks including possible loss of principal. Highlighted risks: credit (risk that the inability or unwillingness of an issuer or guarantor of a fixed income security, or a counterparty to a repurchase or other transaction, to meet its payment or other financial obligations will adversely affect the value of the Funds investments and returns); debt extension (risk that an issuer will exercise its right to pay principal on an obligation held by the Funds later than expected); interest rate/maturity (risk that the value of the Funds fixed income assets will decline because of rising interest rates). In addition, SKOR and LKOR are subject to corporate bond risk, which is the risk that the issuer is unable to meet principal and interest rate payments on the obligation and may also be subject to price volatility due to such factors as interest rate sensitivity, market perception of credit worthiness of and general market liquidity. When interest rates rise, the value of corporate debt can be expected to decline. The Funds may invest in derivative instruments. Changes in the value of the derivative may not correlate with the underlying asset, rate or index and the Funds could lose more than the principal amount invested. The Funds are also non-diversified meaning the Funds performance may depend on the performance of a small number of issuers because the Funds may invest a large percentage of assets in securities issued by or representing a small number of issuers. Duration is the sensitivity of a fixed income security s price to a change in interest rates. flexshares.com The Case for Innovation in Corporate Bond Investing 6 of 8

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8 CONTACT US FINANCIAL PROFESSIONALS By Phone Consultants are available Monday - Friday: 9 AM to 5 PM ET FlexETF ( ) By Mail/Overnight Delivery FlexShares ETFs c/o Foreside Fund Services, LLC 3 Canal Plaza Suite 100 Portland, ME INDIVIDUAL INVESTORS Consult your financial professional for more information on FlexShares Follow Us on LinkedIn FlexShares flexshares.com The Case for Innovation in Corporate Bond Investing 8 of 8 Q58212 (11/15)