Just One ETF: Deflation, Deleveraging Point Investors to High-Yield Debt

Sep.17.10 | About: SPDR Barclays (JNK)
Just One ETF
Several times a week, Seeking Alpha's Jason Aycock asks money managers about their single highest-conviction position - what they would own (or short) if they could choose just one stock or ETF.

Gerald Buetow is a CFA and the chief investment officer of Innealta Capital, a division of Al Frank Asset Management. Previously he was chief investment Officer of XTF Global Asset Management, senior portfolio manager/managing director at Portfolio Management Consultants, and director of research and product development at Atlantic Asset Management.

Which single asset class are you most bullish (or bearish) about in the coming year? What ETF position would you choose to best capture that?

A very difficult question with current global macroeconomic conditions as our backdrop. However, we retain a more bullish stance on fixed income. We still believe that the U.S. Treasury curve has a far higher probability of moving sideways or continuing downward over the coming quarters as deflationary forces continue to take hold of the U.S. economy - forces which are supported by continued weakness across most dimensions of the global economy. We also look at corporate balance sheets very favorably relative to supporting current debt levels throughout the credit sector, especially when one considers the broadly effected rollover of debt into generationally low yields (read: Supporting debt is historically inexpensive).

Digging deeper, on a risk-adjusted basis we continue to like the high-yield market the most. We use the SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK), as well as iShares iBoxx $ High Yield Corporate Bond Fund (NYSEARCA:HYG), throughout our strategies to gain our high-yield exposure. With the current dividend yields greater than 8%, we believe that these exposures offer a very good investment opportunity in the current environment.

How does high-yield debt fit into your overall investment approach?

We currently have three distinctly different investment strategies. The first is what we call the risk-based (RB) strategy; the second is our rotation-based strategy and the third is a fixed-income strategy. Our portfolios use only exchange-traded funds. The RB strategy begins with a traditional multi-asset-class optimization framework, which we tactically / dynamically / adaptively adjust on a relative-allocation basis. Within this strategy we currently have an overweight toward high-yield.

A slight variation of this same approach, called our Opportunity Funds, uses leveraged ETFs to obtain our equity allocations. The equity allocation across both versions is the same, and therefore the leverage enables us to deploy the extra collateral across ETFs that are more income-oriented. Currently, this version has even a more meaningful overweight toward high-yield. Not surprisingly, the leveraged version has outperformed since inception.

JNK chartThe rotation strategies operate differently than the RB strategy. We have a Sector Rotation Portfolio (SRP) and a Country Rotation Portfolio (CRP). Both strategies equally weight equity exposures using a binary decision criterion. The SRP may equally weight each of the 10 large-cap domestic U.S. sectors (10% when bullish/0% when bearish) and the CRP has the potential to equally weight each of 20 world equity markets (5% when bullish/0% when bearish). Each equity allocation is modeled independent of all others; when we are bearish we allocate that proportion of the portfolio (10% for the SRP, 5% for the CRP) to our third strategy, which is an actively managed fixed-income portfolio.

For example, we are currently bullish on only three global equity markets. We therefore have an overall equity allocation of 15% (3 countries each with a 5% allocation). The balance of the portfolio, 85% in this case, is distributed proportionally across our fixed income portfolio, which is currently overweight in high yield. The fixed income strategy has exposures across the Treasury curve, credit, agencies and other bond sectors. We also offer our fixed-income approach as a stand-alone product.

Tell us a little more detail about why high-yield debt is your pick right now.

As I explained, we believe that corporate balance sheets are currently very well positioned in general to support current debt levels. On a relative value basis we feel that the income generation and risk characteristics of high-yield are currently more attractive than most other asset classes.

We believe that risk-free nominal rates will continue to trend lower, creating additional capital appreciation opportunities in the high-yield market. The risks here obviously are that nominal rates increase and that spreads widen. However, we currently believe that with the relatively high yields we are being properly compensated for this risk. Moreover, using ETFs allows us to quickly alter this exposure in the event that this dynamic does indeed come to fruition.

Are there alternative ETFs that could be used to capture the same theme? What makes this specific ETF your first choice?

In general, we like income and capital preservation. We remain very wary of heavily growth-oriented strategies given the secular headwinds facing the global economy. These forces - deflation, deleveraging, high unemployment - are long-term phenomena that are often neglected in our 24/7 news intensive capital markets. So any ETF that has decent income generation and relatively attractive risk characteristics would in theory work within our theme. An example within the equity space would be the utility sector (Utilities Select Sector SPDR Fund (NYSEARCA:XLU)) in our Sector Rotation portfolio.

The proliferation of ETFs has considerably widened the opportunity set. Liquidity, however, remains an issue across many of the newly issued ETFs. As these constraints ease, we will certainly entertain using emerging-market debt ETFs (perhaps PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEARCA:PCY) or a similar ETF) and even those ETFs with preferred stock exposure (PowerShares Preferred Portfolio ETF (NYSEARCA:PGX)) - though the latter is arguably too concentrated an exposure to the financial sector. In our view, JNK currently has superior liquidity characteristics and better income generation than any of these possible alternatives.

Does your view differ from the consensus sentiment on this asset class?

Well, given that fixed income has always been the ugly stepchild within the capital markets, I suppose that sentiment is always somewhat negative - particularly by those equity participants that are always bullish. Most capital market participants have been incorrect regarding the level of interest rates over the last six to 12 months, so we have differed materially over this period. We are far less sanguine regarding growth prospects and far more concerned about deflationary issues here in the United States, sovereign debt issues in Europe and socioeconomic issues in Asia, primarily China. All of these will have a negative effect on most equities over the coming quarters. Clearly, this differs from consensus.

What long-term concerns do you have regarding this asset class?

The obvious long-term issues are how changing monetary and fiscal policies affect rates going forward. Of particular concern are how the government is going to reduce its unsustainable debt levels and how the Federal Reserve is going to unwind its balance sheet. The government absolutely cannot continue its fiscal largesse unabated. It's absolutely unsustainable. If they do, then one could argue that nominal rates eventually will increase. Also at issue is how the Fed unwinds its $2 trillion balance sheet. They were supposed to start unwinding it back in the first quarter, and now they will retain its current size for the foreseeable future. This is a clear indication that current monetary policy is going to continue to be in ultra-accommodative mode for a bit longer.

We fear that much of this policy accommodation is more to meet capital market expectations than it is to meaningfully impact economic growth. In our opinion it seems that the Fed is trying its best to appease Wall Street and not Main Street. Why this announcement was interpreted as good news for equities escapes us. Being kind, however, perhaps the folks at the Fed do indeed see what we see and are trying to counter the nontrivial deflationary forces facing our economy. We just don't see how retaining the current quantitative easing policy does that, particularly when one considers how ineffective it has been since being implemented.

What happens when the Fed actually starts reducing its balance sheet? These dynamics can end up being conflicting or complementary with respect to the direction of interest rates, depending on the policies used to address them. Add the expiring tax code to this already conflagratory combination and estimating the long-term direction of interest rates becomes extremely complicated. Fortunately, much of this dynamic is relatively slow-moving, so we are confident that we will be able to tactically alter high-yield exposures as necessary.

Money's been flooding into debt, and talk of a "bond bubble" has been unavoidable. Regardless of the fundamentals around balance sheets, do you think the values could get far enough out of whack that the risk could become outsized?

Bubble is one of the most misused terms in finance. And “flooding” in has to be taken with some historical perspective - flooding relative to what? On nominal scale, the flows recently pale in comparison to equity flows historically. Why is it that everyone believes it OK to allocate to equities but not fixed income? Historically, bonds are the least represented asset class in portfolio construction - equity has been the asset class of choice - to most investors' (especially retail investors') loss. Bonds remain grossly under-represented and as the secular realities hit portfolio construction we will continue to see more demand for bonds.

Additionally, as the political environment evolves we could see a reduction in Treasury issuance. Both are favorable for bonds. Moreover, monetary policy will most likely continue to push the long end of the curve down. The Fed has no other tools left but to attempt quantitative easing as the economic realities play out. Low growth (if any) lends itself to collecting coupons.

Tom Lydon is also big on this area, and he thinks the biggest risk is defaults. What do you think the likelihood is of some number of defaults affecting JNK in a material way?

I disagree that defaults will be any higher than average, as most corporations are prepared for a long low-growth period. I don’t believe that defaults will be materially different than at any other time in history.

What could go wrong with your pick?

I guess the bottom line here with what could go wrong is that the value of the ETF goes down! After all, it is the price dynamic that manifests the risk dimension. As I briefly explained, the risks are that risk-free nominal rates increase and/or credit spreads widen materially. We believe that this is unlikely in the near term given the current environment. In our opinion, the likelihood of interest rates declining or moving sideways within a trading range is far higher. Given our views on the distribution of both interest rates and spreads we like the income generation, along with the possibility of capital appreciation.

Another concern we have is that ETFs have a tendency to be more correlated with equities than the underlying asset class would otherwise imply. We attribute this characteristic to the proximity of trading on equity exchanges. This, unfortunately, is a very real dilemma for the high-yield ETFs. Tracking error is also an issue with high-yield ETFs, which is only exacerbated by the aforementioned proximity of trading issue. What we do find troubling is the possibility of the high-yield ETF trading off more as a function of an equity correction than anything that has to do with interest rates or credit spreads. We've experienced this phenomenon earlier this spring and certainly in the latter parts of 2008.

Thanks for sharing your thoughts with us!

Disclosure: Long JNK.

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