HYG, JNK, HY17, And Missing The Trees For The Forest

Tyler Durden's picture

The inter-relationships between various credit market and equity market instruments is a regular part of what we discuss, and most importantly, using these potential dislocations to our advantage. The last few weeks have been awash with notes where we have pointed to divergences and convergences both within credit as well as across credit and equity - most recently today's credit-equity divergence. Peter Tchir, of TF Market Advisors, takes a deeper dive to address some of the reasons for the dislocations and why following the relationships we so vociferously highlight can be highly profitable.

At 1:36 today we sent out a message.  At the time HYG was trading at 87.60 and HY17 (the HYCDX) was trading at 91.125 (mid market). HYG closed at 86.70 (or down more than 1% from that level). HY17 finished the day at 91.125 but several dealers commented on how well bid it was into the close. [Today's summary chart highlighted this convergence]

 

In typical Wall Street fashion, the HYG (and JNK) is traded off of the equity desk since it is an ETF.  The CDS guys trade the HY17 and half of them wouldn't look at a bond, let alone an ETF.  That is a problem.  HYG has a market cap of 10 billion.  JNK is just over 8 billion.  These are not insignificant numbers, particularly not in the illiquid junk bond market.

 

HYG had a slow day, but still traded over $200 million.  HY17 had a slow day and probably traded a few billion, so yes, HY17 is more liquid, but the fact that so many "CDS Index" traders ignore these important ETF's is creating opportunities.  Especially when most traditional high yield managers would prefer the HYG/JNK (cash based products) over a CDS product any day of the week.

 

There are some tracking error issues but HYG generally did a better job than JNK (though JNK seems to have changed what it tracks, so we can't find the historicals and it may be trying to correct those errors).  These tracking errors can be worked on over time, and cannot really be worse than the tracking errors of an index based on 100 relatively illiquid single names, which in turn trade differently than the cash bonds of the "Reference Entity".

 

There is something to these ETF's, and either the index traders or the cash traders have to pay more attention.

 

There are still problems with the ETF's.  They have some flexibility over the bonds they hold as they only attempt to approximate the indices.  This is generally good, but as they have gotten bigger, and attracted the attention of the arbs, that is problematic.  Some of the top junk bond managers we talk to, are noticing that the "HYG/JNK" names are trading rich to their peers.  People are ramping up those names in good markets, knowing that inflows will cause the ETF's to buy.  The ETF's are buying at NAV, but the NAV is artificially inflated, because of the early buying (front running has too many negative connotations).

 

More flexibility would help.  A futures contract could also help - as volumes could spike without the corresponding increases/decreases in shares outstanding - we think that in 5 years all people will trade is futures on Bond Indices (whether directly or on the ETF's) and CDS indices will be a distant memory (and we think 5 years is too long, and for many top bond managers, nightmare rather than memory is the correct word).

 

It is a shame that the ETF's cannot get new issue allocations.  In some lean years, new issue flipping can be a big part of a high yield funds returns.  With the size these funds have, getting some new issues allocations would make them even more interesting.  Returns would do a lot better, they would truly offer something that investors cannot get on their own.

 

In response, we think the best mutual funds are doing a better job.  They understand credit selection, the impact of the arb on certain bonds, and the new issue process better.  Those fund managers that are the best should be able to outperform the ETF's and grow assets.  Weaker ones will struggle as they cannot compete with the liquidity or the generic returns.

 

Just like "HYDI's" changed the high yield market forever (thanks Angie and anyone else who is old enough to remember those), these ETF's are having an impact and the best buy side managers (hedge fund and mutual fund) and best sell-side firms will figure out how to truly incorporate the ETF's into their product offering.