Since the number of funds we can cover in-depth is smaller than the number of funds worthy of in-depth coverage, we’ve decided to offer one or two managers each month the opportunity to make a 300 word pitch to you. That’s about the number of words a slightly-manic elevator companion could share in a minute and a half. In each case, I’ve promised to offer a quick capsule of the fund and a link back to the fund’s site. Other than that, they’ve got a few hundred words and precisely as much of your time and attention as you’re willing to share. These aren’t endorsements; they’re opportunities to learn more.
Virtus Newfleet Dynamic Credit ETF (BLHY) is an actively-managed ETF that focuses on two non-investment-grade asset classes, bank loans and high-yield bonds. The fund tries to generate high current income and capital appreciation; because the performance of non-IG assets is relatively interest rate insensitive, it may also provide a rising interest rate hedge.
In normal times, income-oriented investors could count on substantial, predictable returns from very unambitious, core investment grade bond funds. To illustrate that contention we identified the five core bond funds that have been around for 40 years or more, then studied their rolling one, three, five, ten and twenty year annualized returns. Since each fund has up to 20 rolling periods each year (the 1, 3, 5, 10 and 20 year periods following January 1990, then the 3, 5 and 10 year periods following February 1990 and so on), there are a lot of data points (11,955 rolling periods) but only one answer: “about 7.3%.” Historically, it simply didn’t matter how long you held a core bond fund, it was going to return an average of 7.3%. Hold it for one year and, on average, you’d get 7.28%. Hold it for five years and, on average, you’d get 7.32%.
If Dr. John Watson was writing about it, he might recycle the title, The Seven-Per-Cent Solution.
Two caveats: (1) these returns are nominal, not real. If you made 7% and inflation is running at 8%, your real return is negative. Over the long term, inflation runs just above 2% so you might think of your real buying power as growing by about 5% per year. (2) Short-term returns are much more volatile than long-term averages. One of the five funds had one twelve month loss of 25% and one 12-month gain of 55% but that’s out of 700 observation periods. On average and over time, 7.3%.
Back to the question, why? The simplest answer is, future returns – and future risk-adjusted returns – are likely to be dramatically different from the past. Recent analyses published by Morningstar and MFO point to far lower bond fund returns in the future, likely in the range of 0 – 3% real returns with heightened volatility. That’s not good. The picture is further complicated by the changing composition of issuers. Bond benchmarks offer the greatest weight to the most heavily indebted borrowers in a particular class. Federal policy-makers (abetted by economists touting Modern Monetary Theory which describes deficits as harmless) have surrendered any attempt at deficit control; the projected $1.0 – 1.4 trillion federal budget deficit for 2019 requires issuing $1.0 – 1.4 trillion in new Treasury bonds. The weight of traditionally low-yielding Treasuries has doubled in just a decade, and is rising steadily. The New York Times reports:
Over the last decade, as the United States government has issued more and more debt, Treasuries have grown from 22 percent of the index (and index funds) to 40 percent. The index’s Treasury stake is likely to increase in the coming years because the new tax law has reduced corporate tax revenue and a growing federal budget deficit will require more Treasury debt to pay the country’s bills. (Carla Fried, For a While, Bond Funds Were an Exception to the Indexing Rule, 1/11/2019)
That evolution means that investors face falling returns and exposure to fewer issuers, hence more issuer risk. Investors who find that situation intolerable look for income elsewhere: in bond-like equities, financial derivatives, international bonds and in non-investment-grade bonds.
And that’s where Newfleet comes in. Newfleet Asset Management, now part of Virtus, is a $10.5 billion fixed-income manager that specializes in a multi-sector approach. While they don’t quite believe “there’s always a bull market somewhere,” they do believe that there’s always better value somewhere. You might think of them as “disciplined agnostics.” They are not “always and only muni bonds” or “always and only” anything. Instead, they’ve constructed an active strategy that allocates resources between two distinct but convergent non-investment-grade universes.
High-yield bonds can offer equity-like returns with minimal correlation to interest rates. There’s now a $1.1 trillion dollar high-yield market.
Bank loans can offer a powerful hedge against rising interest rates, since the loan interest rates get reset periodically, with the security of knowing that Newfleet is purchasing senior secured loans. There’s now a $1.1 trillion dollar securitized loan market.
While the markets are large, liquid and similar in size, there are significant differences between the two asset classes. By way of example, some industries issue (tech, for example) very few high yield bonds but do participate in the loan market while other industries (energy, as an example) do the reverse. By Newfleet’s calculation, about 800 issuers participate in the bond loan market but not the high-yield market, about 600 do the reverse and only 300 participate in both. The ability to move between the two allows managers to tap into very different income streams, depending on where the best opportunities lie.
Newfleet, through a number of 40-act funds, has been pursuing this strategy since 2014. I had a chance in April 2019 to chat with Paul Privitera, one of Newfleet’s business development guys, and through him with Newfleet’s investment team. Here are Mr. Privitera’s 238 words on why investors ought to consider both an active strategy and exposure to asset classes like high yield and bank loans:
The value proposition behind Dynamic Credit is simple. Over the past decade, high yield bonds are continuing to look more like bank loans and vice versa, so instead of splitting the allocation between both asset classes, we believe investors can more efficiently access the leveraged finance space through a single, flexible strategy. The benefit of this approach is that it enables a single investment manager with purview over a larger opportunity set to capitalize on technical dislocations and differential relative value opportunities within industries, credit quality tiers, and across the capital structure. Additionally, the fund has the ability to utilize Treasuries should conditions warrant, a feature that we feel is especially important to managing risk late cycle and a feature we are currently utilizing.
Given the number of issuers that have a significant presence in both the loan and high yield markets, a plan sponsor or other investor with dedicated strategies may have exposure to an issuer through both its loan and high yield portfolios. In contrast, a manager with a flexible mandate has broader oversight and control over aggregate exposures. Similarly, the use of dedicated strategies may lead to unintentional industry concentration risk or manager style risk that a single-manager, flexible mandate can avoid.
Combining high yield bonds and bank loans in an actively managed strategy takes advantage of the two asset classes’ common and complementary attributes, enhancing diversification and providing the potential for attractive risk-adjusted returns.
This is an actively-managed ETF. While equity investors are used to equating passive with “good and cheap,” that’s not such a sure thing in fixed-income investing. Passive products don’t have a performance advantage over active ones and aren’t all that cheap. The average high-yield ETF – almost all passive – returned 5.76% annually over the past three years. The average high-yield mutual fund – almost all active – made substantially more: 6.17%. Similarly, bank loan mutual funds returned 4.39% while bank loan ETFs clocked in at 3.72% (per Morningstar, as of 5/28/19).
Dynamic Credit was launched in December 2016, has assets of $15.7 million and a 0.68% expense ratio (per Morningstar, 5/28/19). That’s below-average for the bank loan ETF peer group, though above-average for the high yield bond ETF group. Compared to mutual funds, it is below average for both bank loan and high yield. As of March 31, 2019 Newfleet Asset Management had approximately $10.5 billion in assets under management.
The ETF is managed by a team led by David L. Albrycht, Newfleet’s CIO. Mr. Albrycht has crafted a team that’s frequently recognized as being in the industry’s top tier. In addition to this ETF, they manage fixed-income assets through two other ETFs, three closed-end funds, part of all of seven mutual funds and two offshore funds. The Virtus Newfleet Dynamic Credit homepage offers all the basic information, with the Newfleet Flexible Credit Strategy site offering a bit more depth. The difference is that the latter page focused on the performance of somewhat older SMAs and is written with greater detail for an institutional audience.