A number of months have passed since I published my previous series of articles on the Exchange Traded Debt [ETD] market. These articles included the following: Exchange Traded Debt - Strong Income or Looming Overreach?, Building Exchange Traded Debt Ladders, and The Month in Exchange Traded Debt - the Long Bond Edition. Meanwhile, events somewhat akin to a "taper tantrum" occurred in many bond markets during the October - December, 2016 time frame based on expectations of (perhaps rapidly) rising interest rates. For example, the long Treasury market as measured by (NASDAQ:TLT) declined by 12% during this time frame and has had a subsequent recovery of only 2.6%. The ETD market was no exception as many issues fell substantially during this time frame. There was a subsequent recovery in 1Q, 2017. However, this recovery has been quite uneven as various sources of uncertainty hang over many debt markets. The purpose of this article is to provide an updated view of the ETD market after these key events. This will be done by dividing the ETD market into segments; examining the performance of each segment under duress and suggesting subsequent investment strategy in light of recent data.
Early Calls of ETD Issues
My personal expectation going into late 2016 was that there would be a rush of early calls of eligible ETD issues. There was a wide-spread expectation of upcoming rising interest rates and strong demand for new debt issues of even moderate quality. Thus, companies had strong incentives to call existing, relatively high rate debt and replace it with debt at lower rates, longer duration and less stringent covenants. It can also be argued that the ability to call existing debt is a sign of relative financial strength and thus worthy of close attention from investors. Indeed, there were a significant number of early calls as demonstrated by the data in the table below:
I personally held the issues highlighted in the table above. The good news is that I now have a new "stack" of cash to re-invest in alternative opportunities. The bad news is that given the widespread over-valuation in many markets, it often seems that it's getting harder to find attractive new opportunities. A typical example would be Saratoga Investments. I previously held (SAQ) which had a coupon of 7.5%. This issue was called and replaced by (SAB) with a coupon of 6.75% (and the new issue is trading well above par at 25.80 as I type this article).
Examining the ETD Universe
Similar to what I had done in the previous articles on this topic, I divided the ETD Universe into 5 categories:
Short issues defined as those with mandatory maturity through the Year 2030
Intermediate issues - defined as those with mandatory maturity between 2031 and 2046
Long issues - defined as those with mandatory maturity between 2047 through 2056
Very Long issues - defined as those with mandatory maturity in 2057 and beyond
Fixed-to-floating issues - I split out a new category of fixed-to-floating rate issues independent of their maturity dates (note that they are few in number and most mature post-2042). I did this in the expectation that these issues might be especially attractive in the present, highly uncertain, interest rate environment.
Unlike my previous articles, I did not attempt to gather data on all of the existing ETD issues. Instead, I selected what I feel are a representative sample of each category. I proceeded to gather the following data for each issue: the most recent price, the closing price 6 months ago, the lowest price in the last 6 months and the highest price in the last 6 months. I then used this data to calculate the change between the lowest and highest price which I labeled "Top-to-Bottom Delta [TB-Delta]" and the overall price change over the past 6 months which I labeled "6-month Delta". The results are compiled in the two tables below.
I have highlighted several of the issues in these tables based on their relative performance - i.e. you could certainly use this approach as screens for relatively attractive issues based on criteria such as low TB-delta or low 6-month delta. I highlighted issues such as (NYSE:DUKH) and (NYSE:PPX) differently as they have low 6-month delta but perhaps an unacceptable TB-delta. [Note carefully that I am not arguing that these two screen alone should be used for investment decisions]
Analysis of the Resulting Data
So what conclusions and potential investment directions can we draw from this data? My first step was to summarize the data in a much smaller table which allows us to compare market segment averages over the past 6 months. The summary table is presented below:
Super Long ETD
The key conclusions are the following:
- The short ETD segment had the best TB-delta and 6-month delta - i.e. short debt held up well in the downturn and subsequently bounced back to even higher levels. If you are an ETD investor then this is exactly the result that you would have expected and hoped for. In other words, short ETD held up well under stress (low TB delta) and rebounded to at least neutral territory as the economic and political picture became more clear
- The fixed-to-floating segment had an excellent 6-month delta which is what I might have expected given the potential for interest rate resets in a rising rate environment. However, this positive is offset by a disturbing TB-delta which means that potential investors must be willing to absorb significant volatility. Perhaps this should not be surprising as the floating rate resets are several years in the future and the mandatory maturity dates fall into the intermediate or long market segments
- The longer maturity markets segments i.e. the Long and Super Long bounced back from the "tantrum" but at lower levels by on the order of 3-4%. Perhaps more importantly, the TB-deltas ranged from almost 10-12%, a very disturbing result, given the uncertainty of a bounce-back. This once again raises the question initially posed in my article The Long Bond Edition - why would an individual investor want to buy these issues as their maturities are much longer, their coupons lower and they bring the lurking potential for non-recovery over lengthy time frames. These points can be re-phrased as follows - do you really understand the interest rate risk that you are taking and are you prepared for bonds that are deeply "underwater" for lengthy periods of time?
Additional Notes on Fixed-to-Floating Segment
In my view, the Fixed-to-Floating (FTF) segment of the ETD market has received little coverage so it was worth some further investigation. The following points stood out as noteworthy:
- there is an extremely limited set of issues to choose from, only INBKL, HGH, NSS, RZA and RZB have sufficient size and volume. Also noteworthy is that although much of the ETD universe is unrated by major credit rating agencies, the FTF universe has ratings of BB+ (NYSE:HGH), B+ (NSS) and BBB (RZA and RZB)
- all of these issues with the exception of INBKL and NSS have mandatory maturity dates of 2042 and beyond reset dates of 2022 and beyond
- although fixed-to-floating seems like a great idea, as usual you need to delve into the details. The floating rates are linked to 3-month LIBOR (e.g.3 month LIBOR + 4.04%). If the rates were reset TODAY, some would be lower than the current Fixed coupon
- NSS is an example of an issue with highly complex covenants - e.g. interest payments can be suspended without default. NSS also demonstrates potential industry specific issues as the issuing company is tightly linked to the energy complex and traded as low as $17.50 when energy bonds cratered
An Alternative Theory
As usual there are many ways to draw conclusions about the same data. An alternative approach might best be labeled as "Buy the Dip". In other words, many ETD issues (even those of higher quality) dropped significantly between October and December of 2016. For those who had cash to put to work, this could have been taken as an excellent opportunity to aggressively buy issues at attractive entry points. Of course the potential "fly in the ointment" is that at some point, interest rates may mount a steady climb that takes the 10 year treasury to 3% and above. Given that the Long and Very Long ETD segments contain many of the longest duration bonds in the market, this would set the potential for deep, underwater prices that could linger for even 10 -20 years or more.
Closing and Conclusions
The ETD market "tantrum" during 4Q/2016 provided us with a highly useful snapshot of market data which can be used to more deeply analyze the market as well as to drive subsequent investment decisions. I analyzed the data by taking the following steps:
- Segmented the market into key categories and selected a representative sample of ETD issues for each segment
- Defined two screens - the TB-delta and the 6-month delta as lenses to examine the data
- Used the screens to highlight potentially attractive individual issues
- Used the aggregated screen summaries to highlight the impact of changing market conditions on each of the key segments
My overall conclusions were as follows:
· The short duration ETD market held up quite well and bounced back strongly to reach new heights in 1Q2017. This performance re-enforces the view that relatively short maturity ETD are "sweet spot holdings" under a variety of market conditions
· The fixed-to-floating segment rebounded well but first suffered substantial volatility. This could be viewed as a source of "buy the dip" opportunity or as a warning to investors to examine these issues more carefully due to their long duration and sometimes unfavorable covenants and rate-reset provisions
· The Long and Very Long segments remain highly problematic in my view. I continue to wonder if some investors deeply misunderstand the interest rate risk that they are assuming when holding these issues without much apparent reward e.g. higher coupon rates in return. These market segments continue to strike me as rather one-sided with the majority of the benefits going to the issuer
Finally, I plan to returning to writing a monthly article on the ETD market that will utilize these screens in conjunction with other indicators to help identify potentially attractive individual issues.
Addendum - Relevant Tickers
The relevant tickers for the issuers of the Exchange Traded Debt discussed in this article are as follows: (NYSE:ABR), (NASDAQ:CPTA), (NASDAQ:COWN), (NYSE:TCAP-OLD), (NASDAQ:TA), (NYSE:SSW), (NASDAQ:TCRD), (NASDAQ:SOHO), (RAS), (NYSE:NS), (NYSE:VTR), (NYSE:VZ), (NASDAQ:SNH), (NASDAQ:MHLD), (NYSE:TDI)
Disclosure: I am/we are long NSS, ABRN, COWNL, SOHOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am not a financial advisor and I am not offering the reader financial advice. Each reader should perform substantial due diligence and draw conclusions as they see fit