EIC Vs. HYG: An In-Depth Comparison Of 2 High Yield Options

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Summary

  • Today, investors are left searching for income as inflation soars and yields remain substantially compressed.
  • HYG is the world’s largest ETF of non-investment grade corporate bonds.
  • EIC is a closed end fund which invests in junior debt and equity tranches of CLOs.
  • We take a deep look, comparing these two high yield income funds.

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The iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG) and Eagle Point Income Company (NYSE:EIC) are two high yield, fixed income oriented funds with different investment styles and focuses. Today, we compare these two funds, explaining strengths and weaknesses of both as part of a high yield allocation.

Introduction

Let’s review the reality of today’s investment outlook. The world is starved of yield and inflation doesn’t appear to be going anywhere. While inflation was initially called transitory, reality is showing otherwise. Price changes across the spectrum have begun to impact the majority of Americans’ spending habits. It has become a simple reality that although inflation has been tepid over the past decade, the monetary policy of the COVID-19 era has created substantial macro-economic challenges. While the broad economy remains strong, individuals must be proactive to protect themselves and their portfolio from ongoing change.

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Source: US Inflation Calculator

Since the Great Financial Crisis, inflation has remained controlled with limited deviation from the federal reserve’s target rate of approximately 2.0%. The predictability combined with higher yields in other asset classes provided investors with an arsenal to generate value over the crawl of inflationary pressure. However, the upward climb in inflation rates combined with yield compression across various asset classes has resulted in a conundrum. Treasury yields have remained close to a bottom since the depths of COVID-19. Other asset classes have followed suit and today, most yields available will not allow investors to conquer a rate of inflation above 5.00%. Should we enter a prolonged period of inflation, traditional income producing investments will be long term losers for investors looking to place capital in the near future.

Fixed income has historically offered a yield which outpaces the current rate of inflation. As a result, conservative investors have been able to rely on primarily investment grade paper to support a portfolio looking to hedge against movements in asset prices. Today, this is simply no longer the case. Broad bond funds do not have the firepower necessary to conquer an inflationary environment. In fact, the difference is substantial. Take for example, the Vanguard Total Bond Market ETF (BND) with a TTM yield of 2.15%.

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In order to generate the yields necessary to beat inflation, investors are forced to look further down the credit spectrum, accepting more risk as a result. Junk bonds have historically been the logical choice, offering investors higher yields at the expense of balance sheet quality. That said, visibility in financial reporting has allowed investors to make informed decisions, aiding in the navigation of a challenging market. However, fixed income investors should look beyond high yield to other asset classes such as securitized debt to cover our bases. While HYG and EIC are certainly very different in their management and construction, we believe they offer a similar value proposition on a fundamental level. Both funds seek to provide high current income through investment in below investment grade fixed income instruments. Let’s dive into HYG and EIC and analyze their performance and portfolios.

What is the iShares iBoxx $ High Yield Corporate Bond ETF?

HYG is the largest high yield corporate bond fund by assets under management. The fund is managed by BlackRock, the largest asset manager in the world. HYG tracks the iBoxx USD Liquid High Yield Index, a simple and diverse high yield corporate bond index. The index includes all dollar-denominated corporate bonds from developed countries with ratings below investment grade. This is categorized as below BBB- on the S&P Rating scale. The index is weighted by market cap with an issuer cap of 3.00%.

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Source: HYG

HYG is large in assets with over $20 billion under management. The fund has 1,343 different securities, covering materially all the high yield bond universe. Concentration is low, with the largest issuer accounting for 2.07% of the portfolio. With assets well spread across a large number of issuers, the fund is not exposed should any single issuer go under.

HYG is expensive in terms of management fees. The fund's expense ratio of 0.48% is materially higher than other index ETFs. In fact, HYG is more expensive than some other comparable bond funds which is unusual for the iShares lineup of ETFs.

What is Eagle Point Income Company?

Eagle Point Income Company is a closed end fund managed by Eagle Point Credit Management. The fund invests in junior debt and equity tranches of collateralized loan obligations. ECC targets the high-risk tranches with the goal of achieving high total return through current income. The fund invests primarily in junior debt tranches, such as BBB and BB tranches. In total, the fund trades with an equity market capitalization of approximately $121.3 million. Given the fund launched in 2019, we would expect size to remain on an upward trajectory.

Collateralized loan obligations provide exposure to senior secured loans. Debt issued to portfolio companies is secured to assets thus providing lenders direct claim to assets in the event of bankruptcy. Senior secured loans are typically made to companies which have less established credit and may not be able to efficiently access large scale capital markets. CLOs account for the majority of senior secured loan demand.

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Source: EIC

These loans are packaged into actively managed portfolios and tranched out based on payment priority. The finished product is a fixed income instrument with vary degrees of payment security. Higher rated tranches have prioritized claims to cash flow, but their returns are lower. In contrast, lower rated tranches have lasts claim, but their returns are robust. The equity tranche is last in line, only receiving payment should all debt tranches be paid in full.

Understanding the Typical Structure of a CLO

Source: Guggenheim Investments

EIC will invest around 75% of its assets in CLO Debt tranches. The remaining 25% of the portfolio is allocated to CLO equity tranches, providing upside potential in the event of strong markets. The fund intends to primarily target the BB tranche of CLOs, which is usually the final debt tranche to receive payment. As expected, the yields from this tranche are strong, but payments can be unpredictable in times of stress.

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Source: EIC

EIC is one of the few funds which places a concerted focus on CLO investing. Its sister fund, Eagle Point Credit Company (ECC), is a similar fund but focuses on the equity tranche almost exclusively. Additionally, ECC more complex as it acts as Eagle Point’s operating entity for CLO activity. Fortunately, EIC has a simpler management fee structure, charging investors an annual advisory fee of 1.75%. While certainly high compared to many fixed income funds, CLOs are complex investments and management remains highly involved in security selection and management.

Yield Comparison

Given that these two investments have an objective of return through high current yield, let’s see how their distributions stack up against each other.

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EIC offers a forward dividend yield of approximately 8% based on current share prices. Keep in mind, this forward yield accounts for a recent increase to the distribution, nearly matching the fund’s dividend from before the pandemic. The pandemic put a substantial amount of stress on CLOs, however the market’s recovery has surpassed all but the most optimistic expectations. In fact, EIC declared a special dividend of $0.20 per share, payable in January

HYG generates a TTM dividend yield of 4.18% based on current share prices. It’s worth noting that HYG’s distribution has been shrinking as rock bottom interest rates and spread compression allows issuers to refinance debt at historically strong rates. While softening in rates has benefitted share prices for the fund, the interest income generated by the portfolio has shrunk considerably.

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Although both firms have seen decreasing distributions, the yield strength of EIC has helped the fund overshadow HYG in terms of total performance. EIC’s high dividend yield has translated to strong total return, providing substantial upside in the past year as the CLO market continues to heat up. Accounting for the drop of the pandemic, performance has been about even for the two funds going back to EIC’s IPO. That said, HYG has experienced substantially less volatility than EIC during periods of market stress.

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Given EIC’s current yield is nearly double that of HYG, it is crowned the obvious winner in this category. EIC’s yield advantage stems from the higher yields offered by CLOs of a comparable credit rating. BB rated CLOs have an average yield to maturity roughly 5% higher than comparably rated high yield debt.

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Source: EIC

That said, investors should be aware of the elevated volatility levels considering the payment priority structure of CLOs.

Credit Quality

As we mentioned, both HYG and EIC target fixed income securities which are rated below investment grade by major rating agencies. As a result, credit quality becomes important. HYG’s index approach eliminates security selection, allowing forces of market efficiency to determine portfolio construction. While this sounds risky for a high yield strategy, indexing has an extensive and capable history. On the other hand, EIC is actively managed allowing the fund’s management to allocate capital as they see fit.

HYG’s portfolio is comprised of corporate bonds issued by companies which are rated non-investment grade. There are a small number of BBB rated securities in the portfolio which stem from short term changes in rating. That said, the majority of the portfolio is BB rated (54.84%) followed by B rated (33.03%). The remainder of the portfolio is allocated to CCC and below including a small allocation to non rated securities.

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Source: HYG

EIC is similar in construction, given its target of lower rated debt tranches and to a limited extent, the equity tranche. The fund is primarily allocated to BB Rated CLO debt (73.1%) with a much smaller allocated to B Rated CLO paper (1.4%). The remainder of the portfolio is allocated to the equity tranche (25.5%).

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Source: EIC

Credit ratings provide a unique opportunity to compare credit worthiness across assets. While certainly not a direct apples to apples translation, it can provide a guiding sense of the general risk. EIC has a higher allocation to BB rated securities than HYG. With an allocation approximately 20% higher, EIC’s focus on BB securities puts the fund ahead in terms of overall credit quality.

Historical data shows the strength of CLO investments over the long term. In total, There have been 40 BB rated CLO tranches which have defaulted between 1994 and 2019, leading up to the pandemic. That represents a default rate of around 1.4% for a riskier tranche of debt. As displayed below, safer tranches have expectedly performed even better. Across all CLO debt the long term default rates have been just 7 bps per annum.

Only 0.3 Percent of CLO Tranches Have Defaulted Since 1994

Source: Guggenheim Investments

However, credit ratings do not always translate to the real world. Given that we are examining fixed income instruments, understanding the outcomes of bankruptcy is important. The levered loan segment has outperformed high yield debt in terms of both default rates and recovery rates over long time horizons. According to research from Guggenheim, levered loans default at roughly half the rate of high yield paper while maintaining a recover rate that is approximately 20% higher.

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Source: Guggenheim Investments

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Source: Guggenheim Investments

Given the data presented, we conclude that EIC maintains an advantage in credit quality through consideration of published ratings and implied recovery/default rates. The structure of the investments offers a material advantage to shareholders in the event of market stress. While the risky tranches often give investors pause, they are still worth considering given their historically strong performance.

Interest Rate Risk

Rising rates have been a substantial consideration for income investors looking to place capital. Rising rates will have a direct impact on the value of outstanding bonds, while increasing income generated from new issues. Fixed rate instruments will feel the brunt of the force as their established cash flows provide no breathing room against the rising tide of interest rates. However, floating rates will avoid the majority of this burden in the short term as their cash flow adjusts with increases in rates.

HYG has a current duration of 3.81 years meaning a rise in interest rates will impact the fund’s NAV. A 1% increase in rates will correspond to a 3.81% impairment in net asset value, should all other factors remain equal. This is an extremely important consideration given the current yield of the fund is 3.59%. A 1% movement in rates will negate the return produce through the fund’s income for over one year.

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Maturities are well spread for HYG with the majority occurring further out than three years. These longer term holdings leave HYG exposed to changes in rates as their market values will decline as the federal reserve begins to ratchet up interest rates. Declining interest rates have put downward pressure on HYG’s income meaning it no longer has the firepower to fight even modest increases in interest rates. In a silver lining, increasing rates will inevitably translate to higher income as issuers refinance at higher coupons.

In the most recent period of rising rates, HYG struggled to maintain performance. Rising interest rates during 2018 resulted in substantial nav pressure for HYG, leading to a negative return for the calendar year.

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EIC’s investment in CLO debt means the majority of the portfolio is linked to floating rate instruments. Payments of the debt tranches are determined by a spread over LIBOR meaning a bump in interest rates will benefit cash flows in the near term. By focusing on floating rate paper, the fund is well protected from changes in interest rates, actually benefitting through increased cash flow.

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Unfortunately, the fund’s short operating history means we are unable to apply a direct comparison to the same time period. Assuming obligors are able to sustain the elevated interest payments as a result of rising rates, the fund will collect increased distributions from their CLO investments, passing the fruits through to shareholders.

Takeaways

CLOs and high yield debt offer a wide range of similarities and differences. Collateralized loan obligations are complex instruments which are often overlooked by investors due to their opaque structure. That said, long term performance and their ability to combat the power of rising rates means it may be time to take a look. In contrast, HYG offers exposure to a far more familiar asset class. High yield debt is an asset class which occupied a position in many income investors portfolios. However, the fund faces a tough outlook given rising interest rates and a dramatically compressed current yield.

EIC offers an obvious performance advantage as compared to HYG. The fund’s current yield and recovery from COVID has produced substantially better returns over the past twelve months. Should the market remain healthy, this outperformance may continue. This near term outperformance comes with comparable credit quality as well. Having said that, CLOs are far more volatile than traditional high yield debt. As displayed during the pandemic, EIC is far more susceptible to price changes than HYG, meaning conservative investors may be turned off while capital preservation is prioritized.

For investors looking into a short time horizon, the situation becomes difficult. Is the enhanced yield worth stomaching the substantial price risk presented by EIC? Is HYG still attractive knowing a relatively small movement in interest rates has the potential to wipe returns off the map? We would propose that investors looking for a balanced, but strong yield apply a different approach. The barbell approach is typically applied to fixed income investing through maturity laddering. Investors mix long term and short term paper to construct an attractive blended yield. We propose applying similar principals to risk.

HYG offers a yield just shy of 4.00%, which is attractive, but certainly not supercharged. This yield comes at considerable risk given the lower rated holdings in the portfolio. Can this yield be produced through blending a CLO fund like EIC with a conservative fixed income fund such as the iShares 1-5 Year Investment Grade Corporate Bond ETF (IGSB)? IGSB is an ETF of short term, investment grade corporate bonds. The portfolio has a current yield of 1.35% and an effective duration of 2.79 years. The portfolio faces the same issues as it pertains to rising rates, but certainly offers an advantage to shareholders in terms of stability.

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While HYG has outperformed in total return, we can see an increased level of volatility. If investors apply a barbell strategy to EIC and IGSB, could we produce a more attractive yield with limited volatility and better overall protection from rising rates? For a point of reference on volatility, we will use 24 month beta figures. HYG, EIC, and IGSB have 24M Betas of 0.41, 0.75, and 0.08, respectively.

Allocation (EIC/IGSB)

Weighted Average Yield

Weighted Average Beta

20%/80%

2.69%

0.21

30%/70%

3.36%

0.28

40%/60%

4.03%

0.35

50%/50%

4.70%

0.42

60%/40%

5.36%

0.48

70%/30%

6.03%

0.55

80%/20%

6.70%

0.62

Source: Author using data from Seeking Alpha

With a 40/60 split between EIC and IGSB, we produce a yield over 4.00%, while maintaining a lower beta over a long time horizon. Additionally, the split benefits from upside in rising rates for EIC, potentially offsetting the pressure on IGSB.

Fixed income is a category where it truly pays to think outside of the box. The current environment combines extremely low yields with a rate of inflation which outpaces the last decade. As a result, income investors are struggling to assemble strategies to fight a challenging outlook. Investors willing to accept more risk, may chase a more aggressive split which could even beat the rate of inflation, assuming market factors permit. However, as it stands today, we believe EIC is a more attractive option as compared to HYG based on rising rates, current yield, and long term default rates.

Conclusion

These two funds offer a similar value proposition with different strategies for execution. While both offer exposure to non-investment grade securities, CLOs are inherently more complex in construction and management. In fact, EIC is one of few closed end funds dedicated to tackling the space. We believe both investments have their merits, but ultimately EIC overshadows HYG given the economic outlook. That said, shareholders should be prepared to handle volatility with the strong yield.

This article was written by

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Obsidian Limited provides investors with income focused insights and research. We identify and cover opportunities across asset classes with a focus on appreciating cash flow.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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: This article is not investment advice. Research provided in this article is supportive of your own thorough and complete due diligence. Please consult your investment advisor on opportunities presented herein.

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