ETF Investment Solutions How to Target the Bond Market s Sweet Spot with Crossover Bonds

Transcription

1 ETF Investment Solutions How to Target the Bond Market s Sweet Spot with Crossover Bonds CONTENTS I. ASSET CLASS BACKGROUND What Are Crossover Bonds? II. CHARACTERISTICS OF CROSSOVER BONDS What Are the Characteristics of the Issuing Companies? III. INVESTING IN CROSSOVER BONDS Who Should Invest In Crossover Bonds? Portfolio Construction with Crossover Bonds IV. ETF INVESTING SPDR BofA Merrill Lynch Crossover Corporate Bond ETF (XOVR) KEY BENEFITS Crossover bonds combination of investment-grade and high-yield bonds seeks to deliver Attractive yield, higher than most investment-grade bonds Moderate credit risk, lower than most high-yield bonds Medium-term duration. Many higher-yielding corporate bonds have shorter maturities, so crossovers may have lower duration (sensitivity to interest rate changes) than investment-grade bonds which typically have longer maturities In addition, crossover bonds dual exposure to the investment-grade and high-yield markets may reduce the need to tactically re-allocate during changing market cycles. I. ASSET CLASS BACKGROUND WHAT ARE CROSSOVER BONDS? Crossover corporate bonds occupy the space on the risk spectrum where investment grade meets high yield. As the lowest-rated investment-grade bonds (rated BBB by S&P or Fitch, or Baa by Moody s) and the highest-rated high-yield bonds (rated BB by S&P or Fitch, or Ba by Moody s), crossovers may have less credit risk than most high-yield bonds, but with higher yields than most investment-grade bonds. FIGURE 1: S&P RATINGS BREAKDOW INVESTMENT GRADE HIGH YIELD DEFAULT S&P RATINGS AAA AA A BBB BB B CCC CC C Source: Standard & Poor s, SSgA, as of 6/30/2013. D CROSSOVER SECURITIES Notably, crossovers may also be referred to as split rating bonds, because they may be rated investment grade by one rating agency and high yield by another. II. CHARACTERISTICS OF CROSSOVER BONDS WHAT ARE THE CHARACTERISTICS OF THE ISSUING COMPANIES? Generally, crossover bond issuers can be grouped into one of two categories: RISING STARS can be emerging or start-up companies without a long history of financial results. For example, those with BB status may have not yet achieved the operational history, size and/or capital strength needed to earn an investment-grade credit rating. More established companies where improving fundamentals result in upgrades from ratings agencies also fit here. FALLEN ANGELS are former investment-grade companies that have been demoted to below investment grade by the ratings agencies. This can occur when issuers face difficulty and see a decrease in corporate fundamentals. If these companies business prospects deteriorate further, they may be downgraded further into junk status. However, struggling companies may subsequently recover and are eventually upgraded back to investment grade. Potential mispricings created by a security s movement between investment-grade and high-yield ratings can lead to opportunity. When a company becomes a fallen angel, its bonds generally lose value in part because investment-grade exchanged traded funds (ETFs) and mutual funds may be forced to sell their holdings in the company. This may create opportunities to buy relatively strong debt at discounted prices. spdrs.com spdru.com

2 Conversely, when a rising star or fallen angel is upgraded from high-yield to investment-grade status as Fitch and Moody s recently did with fallen angel Ford Motor Company bondholders will generally see the value of their bonds appreciate as investors recognize the improved corporate fundamentals. Because of these mispricings, the crossover space may offer a potential opportunity, reflected in total return, than some other areas of the bond market. Earning the credit risk premium associated with the high-yield market is the primary motivation for investing below investment grade. III. INVESTING IN CROSSOVER BONDS WHO SHOULD INVEST IN CROSSOVER BONDS? Institutional investors and financial advisors alike use crossover bonds as a tactical play to increase yield and reduce risk. The asset class is sometimes also used as a standalone allocation to corporate bonds. If you segment the corporate bond market along traditional lines, allocating separately to investment grade and high yield either on a strategic or tactical basis, introducing crossover bonds into portfolios gives you an additional tool when making these decisions. In fact, since crossovers straddle investment grade and high yield, they offer additional precision for the following investors: CONSERVATIVE INVESTORS LOOKING TO INCREASE YIELD: Crossover bonds enable investment-grade bond investors with a greater risk appetite and the need for additional yield to move just beyond the investment grade line for potentially greater returns. Additionally, in an environment where interest rates may increase, crossover bonds lower duration is beneficial. RISK-AVERSE INVESTORS: As the Fed has anchored short-term interest rates, many investors have moved into junk bonds for the additional yield that they can provide. If market uncertainty magnifies the risks of high yield, an allocation to crossovers may provide some of the inherent benefits of investment grade without sacrificing too much upside. INVESTORS SEEKING MIDDLE-OF-THE-ROAD CORPORATE BOND EXPOSURE: Straddling investment grade and high yield, crossovers represent a unique all-in-one solution to investing in corporate bonds. FIGURE 2: INDEX CHARACTERISTICS DURATION AVERAGE YIELD TO (%) OPTION ADJUSTED SPREAD Barclays U.S. Aggregate Index Barclays U.S. Treasury Index Barclays U.S. Very Liquid High Yield Index BofA Merrill Lynch US Diversified Crossover Corporate Index Barclays U.S. Corporate Index Past performance is not a guarantee of future results. The index returns are unmanaged and do not reflect the deduction of any fees or expenses. The index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. PORTFOLIO CONSTRUCTION WITH CROSSOVER BONDS In today s yield-starved market environment, investors are seeking income greater than what broad market bond or Treasury funds can provide. In many cases, they have sought out additional yield opportunities by extending duration or moving into corporates (see Figure 2). In a hypothetical case, an investor might begin by allocating 35% of their fixed income portfolio to Treasuries (which is similar to the weighting Treasuries comprise in the US Aggregate Index) and the remaining 65% of the portfolio might be allocated to corporates. This portfolio (labeled as Portfolio A in Figure 3) would provide a yield of 2.61%, which is 40 basis points greater than the Aggregate. However, the duration of the portfolio would increase from 5.49 to 6.27, which may not be suitable for investors concerned with taking on too much interest rate risk. One mechanism for increasing yield and reducing duration would be to introduce high-yield bonds into the portfolio. For example as depicted in Portfolio B, while maintaining the same weight to Treasuries, an investor could make their allocation to corporates entirely in high yield, which would increase the yield to 4.83% and lower the duration to However, in this scenario the Option-Adjusted Spread would increase significantly. Again, for the right investor this may be appropriate, but others may find the spread risk too great. A more realistic approach would be to take some of the corporate allocation (as shown in Portfolio C) and split it between investment grade and high yield. In this case, an allocation of approximately 35% to Treasuries, 43% to investment grade and 22% to high yield may be reasonable. This move would increase the yield to 3.36% and bring the duration to 5.78, which is about 50 basis points less than the pure allocation to investment grade bonds. A further means of targeting yield and duration would be to introduce crossover bonds into the mix. In this scenario, an investor would discontinue making an allocation to both investment grade and high yield. Depicted above as Portfolio D, an investor would target a 65% allocation to crossovers, which would yield 3.43% with a duration of The allocation to crossovers in this case may be extreme, but it shows how the asset class can be used as an additional tool to precisely target portfolio exposures. Furthermore, an investor could still target a higher yield, but seek to ensure that the FIGURE 3: HYPOTHETICAL PORTFOLIO CHARACTERISTICS DURATION AVERAGE YIELD TO (%) OPTION ADJUSTED SPREAD Portfolio A Portfolio B Portfolio C Portfolio D Portfolio E For Illustrative Purposes only. Crossovers are represented by the BofA Merrill Lynch US Diversified Crossover Corporate Index, Investment Grade is represented by the Barclays U.S. Corporate Index, High Yield is represented by the Barclays U.S. Very Liquid High Yield Index and Treasuries are represented by the Barclays U.S. Treasury Index. 2

3 duration did not exceed that provided by the US Aggregate Index. For example, an investor could target the yield found in the previous example with investment grade and high yield, but with a lower duration. In this case, as shown in Portfolio E, the investor would allocate 35% to Treasuries, 22% to investment grade, 32% to crossover and 11% to high yield. IV. ETF INVESTING SPDR BOFA MERRILL LYNCH CROSSOVER CORPORATE BOND ETF (XOVR) The SPDR BofA Merrill Lynch Crossover Corporate Bond ETF (XOVR) seeks to provide investment results that, before fees and expenses, correspond generally to the price and yield performance of the BofA Merrill Lynch US Diversified Crossover Corporate Index. The Index is designed to measure the performance of US dollar denominated BBB and BB corporate debt publicly issued in the US domestic market. Crossover corporate debt generally means corporate debt rated at levels where the lower end of investment grade debt and the higher end of high-yield debt meet. Qualifying securities must be rated BBB1 through BB3, inclusive (based on an average of Moody s, S&P and Fitch). As exhibited in Figure 4, the BofA Merrill Lynch US Diversified Crossover Corporate Index offers targeted exposure to the BBB and BB components of the corporate bond market. As of June 30, 2013, 51.14% of the index was rated Baa or greater. Conversely, 48.86% of the index was rated Ba or below. Relative to the Barclays US Corporate Index, the BofA Merrill Lynch US Diversified Crossover Corporate Index has greater exposure to Baa and relative to the Barclays US Very Liquid High Yield Index, the BofA Index has a larger allocation to Ba. FIGURE 4: RATINGS BREAKDOWN BY MARKET VALUE (%) MARKET VALUE [%] FIGURE 5: SECTOR EXPOSURES BY MARKET VALUE (%) SECTOR BARCLAYS US VERY LIQUID HIGH YIELD INDEX BARCLAYS U.S. CORPORATE INDEX BofA MERRILL LYNCH US DIVERSIFIED CROSSOVER CORPORATE INDEX Industrial Utility Financial Institutions Agency Sector allocation are as of the date indicated, are subject to change, and should not be relied upon as current thereafter. The BofA Merrill Lynch US Diversified Crossover Corporate Index has unique sector exposures relative to the Barclays US Corporate Index and the Barclays US Very Liquid High Yield Index. For example, the Crossover Corporate Index has less exposure to financials than the Corporate Index, but more exposure than the High Yield Index. In addition, the Crossover Corporate Index has more industrial and utility sector exposure than the Corporate Index, but not as much as the High Yield Index. Crossover bonds offer potential opportunities in the bond market for investors seeking yield in today s historically low interest rate environment. By historically offering greater yield than most investment-grade bonds and less credit risk than most high-yield bonds, the crossover pace may provide an attractive option for investors seeking to move higher on the yield curve while seeking to minimize risk. The SPDR BofA Merrill Lynch Crossover Corporate Bond ETF seeks to provide investors with cost-effective, tax-efficient access to the entire crossover space within the bond market in one trade. RATING BofA MERRILL LYNCH US DIVERSIFIED CROSSOVER CORPORATE INDEX BARCLAYS US VERY LIQUID HIGH YIELD INDEX BARCLAYS U.S. CORPORATE INDEX Aaa Aa A Baa Ba B Caa Ca C Barclays uses the middle rating of Moody s, S&P and Fitch to determine a security s index classification. If only two of the agencies rate a security, then the most conservative (lowest) rating will be used. If only one rating agency rates a security, that one rating will be used. Where there are no security level ratings, an issuer rating may be used to determine index classification. Barclays Index breakdowns are grouped into larger categories. For example, AAA+ and AAA are listed as Aaa; AA1, AA2 and AA3 are listed as Aa, etc. 3

4 INDEX DEFINITIONS BARCLAYS U.S. AGGREGATE INDEX The Barclays U.S. Aggregate Index represents the securities of the U.S. dollar-denominated, investment grade bond market. The Index provides a measure of the performance of the US dollar-denominated, investment grade bond market, which includes investment grade (must be Baa3/ BBB-or higher using the middle rating of Moody s Investor Service, Inc., Standard & Poor s, and Fitch Rating) government bonds, investment grade corporate bonds, mortgage pass through securities, commercial mortgage backed securities and asset backed securities that are publicly offered for sale in the United States. BARCLAYS U.S. CORPORATE INDEX The Barclays U.S. Corporate Index is designed to measure the performance of US corporate bonds that have a maturity of greater than 1 year. The includes investment grade, fixed-rate, taxable, US dollardenominated debt with $250 million or more par amount outstanding, issued by US and non-us industrial, utility, and financial institutions. The Index is rebalanced monthly, on the last day business day of the month. BARCLAYS U.S. TREASURY INDEX The Barclays U.S. Treasury Index includes all publicly issued, US Treasury securities that are rated investment grade, and have $250 million or more of outstanding face value. In addition, the securities must be denominated in US dollars and must be fixed rate and non convertible. Excluded from the US Treasury Index are certain special issues, such as flower bonds, TINs, state and local government series bonds, TIPS, and coupon issues that have been stripped from bonds included in the index. The Index is market capitalization weighted and the securities in the index are updated on the last business day of each month. BARCLAYS U.S. VERY LIQUID HIGH YIELD INDEX The Barclays High Yield Very Liquid Index includes publiclyissued, US dollar-denominated, non-investment grade, fixedrate, taxable corporate bonds that have a remaining maturity of at least one year, regardless of optionality, are high-yield using the middle rating of Moody s, S&P, and Fitch, respectively, and have $600 million or more outstanding face value. BOFA MERRILL LYNCH US DIVERSIFIED CROSSOVER CORPORATE INDEX The Index is designed to measure the performance of US dollar denominated BBB and BB corporate debt publicly issued in the US domestic market. Crossover corporate debt generally means corporate debt rated at levels where the lower end of investment grade debt and the higher end of high yield debt meet. Qualifying securities must be rated BBB1 through BB3, inclusive (based on an average of Moody s, S&P and Fitch). Qualifying corporate issuers must have a primary risk exposure to an FX G10 or Western European country, or a territory of the US or a Western European country. Individual securities of qualifying issuers must have a fixed coupon schedule and a minimum amount outstanding of $250 million. Original issue zero coupon bonds and 144a securities, both with and without registration rights qualify for inclusion. Callable perpetual securities qualify provided they are at least one year from the first call date. Fixed-to-floating rate securities also qualify provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. Eurodollar securities (USD securities not issued in the US domestic market), pay-in-kind securities, toggle notes, Tier 1 subordinated debt, taxable and tax-exempt US municipal, warrantbearing, DRD-eligible and defaulted securities are excluded from the Index. Qualifying constituents are segmented into two groups: those rated between BBB1 and BBB3, inclusive, and those rated between BB1 and BB3, inclusive. Within the two groups, constituents are capitalizationweighted. Each group is then assigned a 50% weight in the overall ind ex; with a 2% cap on each issuer. Accrued interest is calculated assuming next-day settlement. Cash flows from bond payments that are received during the month are retained in the index until the end of the month and then are removed as part of the rebalancing. Cash does not earn any reinvestment income while it is held in the Index. The Index is rebalanced on the last calendar day of the month, based on information available up to and including the third business day before the last business day of the month. Issues that meet the qualifying criteria are included in the Index for the following month. Issues that no longer meet the criteria during the course of the month remain in the Index until the next month-end rebalancing at which point they are removed from the Index. As of March 31, 2012, there were approximately 2,918 securities in the Index and the modified adjusted uration of securities in the Index was approximately 5.54 years. 4

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