The Evolving High Yield Market

The Evolving High Yield Market 214 3Q Newsletter When you re finished changing, you re finished. Benjamin Franklin Given the recent volatility in high yield markets, we thought it would be useful to examine how the market has evolved since the 28 financial crisis. Specifically, we will explore three major developments in the high yield market since the global financial crisis: 1) the role of Exchanged Traded Funds (ETFs), 2) trading/liquidity influences, and 3) the changing high yield investor base. I. The Role Of High Yield Exchanged Traded Funds There has been a lot of media attention regarding ETFs and their impact on fund flows. How big has the impact been? We will answer this question by examining high yield ETFs within the context of the overall high yield market and then evaluate how it has changed since the 28 financial crisis. Total high yield ETF assets under management (AUM) have grown over the past several years. At the end of 28, high yield ETFs AUM were $2.4B. By the end of 213, 27 different high yield ETFs accounted for roughly $35B in assets with nearly all those assets in USD denominated and US domiciled issuers. The estimated size of this market is $1.3T; high yield ETFs AUM represent only 3% of this market, up from.3% in 28. The increased prominence of high yield ETFs has influenced trading considerably. ETF Bid-Wanted lists (a list of bonds that ETFs are trying to sell) and ETF Offer-Wanted lists (a list of bonds that ETFs are trying to buy) are attention grabbing because they can be sizeable and are broadcast multiple times throughout the day. However, ETF trading volume as a percentage of total estimated high yield trading is relatively small. There is not a precise way to calculate total ETF trading activity, but Citigroup s high yield strategist estimated that ETF high yield average daily trading volume represented roughly 2.3% of total average daily Trade Reporting and Compliance Engine (TRACE) volume in 213. This is up from less than 1% in 29. Because ETF volume is driven by flows into/out of the funds, trading volume can change significantly from one day to the next. For example, daily ETF trading volume as a percentage of total daily TRACE volume ranged from.6% to 5.1% in 213 depending on the day as shown in Chart I. These numbers look reasonable given that high yield ETF assets represent only 3% of overall assets. On days when high yield ETF trading exceeds 5%, the effect is felt by the high yield market. This was especially the case in the early days of ETF operations due to composition rules that limited ETFs to a relatively narrow range of names, which resulted in concentrated portfolios. Recognizing this limitation and its effect on tracking error, high yield ETFs made considerable changes to both compositional definitions and trading behavior in the last two years. These changes, intended to reduce trading slippage, appear to have had some success. Chart I: Estimated ETF Volume/High Yield Trace Volume 6% 5% 4% 3% 2% 1% % Jan-9 Apr-9 Jul-9 Oct-9 Jan-1 Apr-1 Jul-1 Oct-1 3.1% We believe investors should pay attention to their cross holdings with the four major ETFs (HYG, JNK, SJNK, and HYS). This is important for multiple reasons. First, ETFs are black box investment strategies, meaning buy/sell decisions are driven by predetermined rules rather than human investment decisions. Second, high yield ETFs have a liquidity match problem. Flows must be accommodated in a very short period, but the underlying high yield asset class has limited liquidity. These factors can produce violent price moves in ETF names and create opportunities for active high yield investors. Therefore, investors should be cognizant of the 1,344 bond issues held in the four major ETFs and their respective exposure to those issues. At the beginning of August, the four major ETFs had overlap with Hotchkis and Wiley accounts of only 5.3%. Finally, there appears to be some linkage between ETF and high yield mutual fund flows. A recent JPMorgan report studied this

214 3Q NEWSLETTER observation and found that high yield ETF flows tend to lead actively managed high yield mutual fund flows by one to two weeks. The reasoning is that high yield ETFs are used by fast money investors (e.g. hedge funds) to gain access to the high yield market, effectively exploiting the liquidity mismatch. Viewed as the marginal buyers/sellers in the market, flow activity in ETFs should lead to more stable, long-term investors, who typically favor high yield mutual funds. This causality implies that actively managed mutual fund flows will be negative if ETFs experience outflows the prior week and vice versa. In practice, we have observed this phenomenon and found this data useful as a signaling point when managing liquidity. II. High Yield Trading/Liquidity Influences There has been a lot of press about how the high yield market is becoming less liquid because of declines in dealer inventory. This inventory decline stems from restrictive risk capital measures post the 28 financial crisis. While this is a rational contention, actual trading volumes fail to corroborate. Current daily trading volumes in high yield securities that are tracked by FINRA s TRACE system are actually higher than the previous peak of $6.5B par traded per day back in 26. According to FINRA, average daily high yield par trading volume of $9.8B in 213 was up 5% from 26 across 144a and registered high yield securities. The US high yield market has grown in size, however, by 52% to roughly $1.3T in 213. Chart II shows that trading volume relative to high yield assets are slightly higher at.82% in 213 relative to.78% in 26. Chart II: High Yield Daily Trading Volume Average Daily Par Volume (right scale) Chart III: High Yield Bond Issues Traded Daily (5-day avg) 2, 1,8 1,6 1,4 1,2 1, 8 6 4 2 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 Jan-9 Jul-9 Jan-1 Jul-1 Another piece of the puzzle is dealer behavior. Dealer corporate bond inventory has declined since the end of the 28 financial crisis. In April 213, the Federal Reserve Bank of New York began breaking down dealer inventory by corporate bond type into: commercial paper, investment grade, and high yield. Prior to this, only aggregate level data was available. Since 28, primary dealer positions in corporate securities have declined from a high of $235B to roughly $55B by early April 213 (Chart IV), which is a nearly 8% decline. Over the past 18 months, reported dealer corporate high yield inventory has averaged roughly $7B. The press is focused on this data since it can be used as an indirect measure of a financial intermediary s willingness to put capital at risk and hence provide liquidity when clients need to buy or sell bonds. Chart IV: Dealer Inventory of Corporate Bonds 1,755 1.% % of US HY Market Size (left scale) $1 All Corporates (left scale) HY (right scale).8%.6%.4%.2%.% 25 26 27 28 29 21 211 212 213 As trading volume increased, the total number of high yield issues traded per day has also increased a market breadth indicator as shown in Chart III. Market breadth has increased considerably since the end of the financial crisis. $8 $6 $4 $2 $ Billions $B Total Corporate Inventory 25 2 15 1 5 Jul-1 Jul-2 Jul-3 Jul-4 Jul-5 Jul-6 Jul-7 Jul-8 Jul-9 Jul-1 How do we square the fact that trading volumes are up and breadth has increased despite lower dealer inventory levels since the end of the 28 financial crisis? To evaluate this, we 9 8 7 6 5 4 3 2 1 $B Total HY Inventory H&W 725 South Figueroa Street, 39th Floor, Los Angeles, CA 917 1-888-596-4926 www.hwcm.com 2 of 5

214 3Q NEWSLETTER look at trading costs. The first inclination is that transaction costs should be higher with less liquidity provided by the dealer community, but data from MarketAxess indicate that trading costs have actually declined since 28. FINRA s TRACE began providing dealer buy-sell indicator in 28. The indicator s methodology is to match bonds that dealers purchased and sold on the same day, and then measure the price difference to determine transaction costs. Chart V shows the average bid/ask on a daily basis using TRACE data from the top 1, high yield securities based on volume. The data shows that the average price bid/ask has declined from roughly 7/8th of a point in late 28 to roughly 3/8ths currently. Chart V: Bid/Ask Price Spread.9.8.7.6.5.4.3.2.1 Oct-8 Jan-9 Apr-9 Jul-9 Oct-9 Jan-1 Apr-1 Jul-1 Oct-1 How do we rationalize that average trading costs are down nearly 5% despite higher trading volumes, increased breadth and lower dealer inventory levels? There is not a simple answer, but we think a couple of issues have transpired. First, the trading information available to investors has improved markedly over the past 5 years. While the dealer community bemoaned the advent of TRACE pricing, it has lowered the cost of price discovery for high yield investors. Over the last 8 years, trading information available to investors improved dramatically as a result of the following three improvements: 1) real-time trade reporting to TRACE became a requirement in 26, 2) dealer buy-sell indicator disclosed in 28, and 3) 144a bond (private) trades became TRACE eligible in 214. These improvements helped to level the playing field between dealers and investors which led to lower bid/ask prices in high yield bonds. Second, transparency has encouraged riskless intermediaries to enter the market and claw share away from the traditional dealer community. In turn, this has successfully goaded dealers into a riskless or an agent approach to trading; i.e., they take no inventory and earn the bid-ask spread by bringing market participants together. In our experience, we have seen the number of counterparties double over the past 1 years. We believe it is the combination of improved transparency and the corresponding migration to a riskless/agent trading model that explains much of the improvement in the liquidity and cost of trading high yield bonds. Finally, there is the emergence of electronic platforms. Companies like MarketAxess are electronic portals that provide a way to bid for bonds directly with an investor bypassing the need for a dealer (the electronic platform collects a fee). MarketAxess claims that its market share in high yield trading has climbed from roughly 1% to 5% from 28 to 213. In the high yield synthetic market, the story is similar. As shown in Chart VI, we have a history of total dollar net notional exposure of 1) all investment grade and high yield CDX indexes and 2) high yield CDS single name outstanding across counterparties. Since 28, total investment grade and high yield CDX indexes net notional exposure has declined from $1.4T to roughly $1T today. Similarly, single name high yield CDS net notional declined from roughly $14B in 29 to $65B today. The single name high yield CDS number only includes high yield names that fall within the top 1, traded single name CDS. Chart VI: Dealer Inventory in Synthetics $B CDX HY & IG Notional 1,6 1,4 1,2 1, 8 6 4 2 CDX HY & IG Net Notional (left scale) HY CDS Single Name (right scale) Oct-8 Jan-9 Apr-9 Jul-9 Oct-9 Jan-1 Apr-1 Jul-1 Oct-1 16 14 12 1 8 6 4 2 Dealers have become less willing to put capital at risk due to new regulatory requirements. Thus, dealer cash and synthetic corporate bond inventory levels have declined dramatically since the 28 financial crisis. However, despite these declines, trading volumes and liquidity have kept pace with the asset growth in high yield and trading costs have declined to prefinancial crisis levels. Today, high yield investors are armed with better trading information and have liquidity avenues across $B HY CDS Single Name H&W 725 South Figueroa Street, 39th Floor, Los Angeles, CA 917 1-888-596-4926 www.hwcm.com 3 of 5

214 3Q NEWSLETTER various electronic platforms. This has helped support trading volumes and push trading costs lower. We are concerned that in some (hopefully distant) future crisis, the lack of dealer support may produce more rather than less volatility for the high yield market. Agent trading strategies and electronic portals combined with real-time pricing transparency may not be enough to buffet pricing when a large swath of investors head for the exit. However, this can be offset somewhat with a dedicated investor base that is comfortable buying bonds at the end of the credit cycle. III. The Changing High Yield Buyer Base While the high yield market has evolved from a closed system to more of an open system, the buyer base has changed as detailed in Table I. Traditionally, the high yield buyer base consisted of high yield-related funds, investment grade-related funds, insurance companies, and pension funds. This traditional high yield buyer base has consistently held roughly 8% of all US high yield assets from 25 to 213. The most significant change since 25 has been the emergence of foreign accounts buying US high yield assets increasing from 6.8% in 25 to 15.1% in 213. This suggests that the US high yield market is now more intricately connected on a global scale as investors canvass the world for investment alternatives. Table I: US High Yield Market Investor Base 28 29 21 211 212 213 High Yield Mutual Funds 16.5% 18.1% 17.8% 18.6% 23.5% 24.2% Investment Grade Mutual Funds 8.6% 8.% 8.8% 7.5% 6.8% 6.2% Insurance Companies 26.4% 25.1% 25.4% 24.9% 23.6% 24.1% Pension Funds 2.3% 2.9% 21.9% 22.5% 22.8% 23.2% CBOs 6.9% 4.2% 2.7% 1.8% Equity and Income Funds 9.1% 9.9% 8.6% 8.% 4.8% 3.7% Foreign 7.2% 7.% 9.6% 12.% 14.6% 15.1% Hedge Funds & Other 4.9% 6.9% 5.2% 4.7% 3.9% 3.5% The global high yield asset class is also becoming less US centric. Historically, the US high yield market has comprised 8% of the estimated global high yield market, but this has declined to 7% in the last six years. This was primarily driven by growth in global issuers actively refinancing their Euro-denominated loans with new bonds. The global high yield market (including all USD and Euro-denominated issuance from global high yield issuers) is approximately $1.8T in size, almost 2X larger than just 1 years ago. Only Euro-denominated loans have declined during this period as shown in Table II. Table II: Growth in Global High Yield 28 29 21 211 212 213 Bonds (in billions of US dollars) USD denominated High Yield bonds 857 985 1,14 1,115 1,121 1,273 Euro denominated High Yield bonds 113 125 17 186 22 274 Other High Yield bonds 87 126 215 173 38 289 Total High Yield bonds 1,57 1,236 1,399 1,474 1,649 1,836 Loans (in billions of US dollars) USD denominated loans 65 527 497 53 576 729 Euro denominated loans 24 189 185 146 135 131 Total loans 89 716 682 676 711 86 Total HY bonds + loans (in US dollars) 1,866 1,952 2,81 2,15 2,36 2,696 Conclusion The high yield market has evolved considerably since the 28 financial crisis. The most important changes are 1) the decline in dealer s willingness to put capital at risk and 2) the changing buyer base of US high yield assets as foreign demand plays a larger role. Since the 28 financial crisis, high yield ETF assets have grown but as a percentage of AUM and trading volume, remain relatively small. With regards to trading, decreased liquidity provided from dealers has not affected trading volumes or trading costs materially. Better trading information, transparency, and the development of agent models and electronic platforms have helped push trading costs lower. This has also supported volumes to keep pace with the growth of high yield assets. The high yield buyer base has changed significantly with foreign accounts now comprising 15% of US high yield assets held while the traditional high yield buyer base remains consistent at 8%. Despite these changes in high yield market technicals, we continue to believe that fundamental bottom-up credit selection remains the key to outperformance in the long-term. As stewards of our client s capital, we pay close attention to high yield technicals since it can affect short-term liquidity and present near-term opportunities; but in the long-term, fundamentals triumph. Hotchkis & Wiley High Yield Research All investments contain risk and may lose value. Investing in high yield securities is subject to certain risks, including market, credit, liquidity, issuer, interest-rate, inflation, and derivatives risks. Lower-rated and non-rated securities involve greater risk than higher-rated securities. High yield bonds and other asset classes have different risk-return profiles, which should be considered when investing. H&W 725 South Figueroa Street, 39th Floor, Los Angeles, CA 917 1-888-596-4926 www.hwcm.com 4 of 5

214 3Q NEWSLETTER Data source(s): Chart I: Citigroup, FINRA; Chart II: FINRA, JPMorgan; Chart III: FINRA, Bloomberg; Chart IV: Bloomberg, NY Fed; Chart V: MarketAxess; Chart VI: JPMorgan. Tables I & II: JPMorgan. 214 Hotchkis & Wiley. All rights reserved. Any unauthorized use or disclosure is prohibited. This material is for general information only, and does not have regard to the specific investment objectives, financial situation and particular needs of any specific person. It is not intended to be investment advice. This material contains the opinions of the authors and not necessarily those of Hotchkis & Wiley Capital Management, LLC (H&W). The opinions stated in this document include some forecasted views, which are believed to be based on reasonable assumptions within the bounds of current and historical information. However, there is no guarantee that any forecasts or views will be realized. Any discussion or view on a particular asset class or investment type are not investment recommendations, should not be assumed to be profitable, and are subject to change. H&W has no obligation to provide revised opinions in the event of changed circumstances. Information obtained from independent sources is considered reliable, but H&W cannot guarantee its accuracy or completeness. For Investment Advisory clients. H&W 725 South Figueroa Street, 39th Floor, Los Angeles, CA 917 1-888-596-4926 www.hwcm.com 5 of 5