The Markit iTraxx Crossover index, a measure of the default risk on 50 sub-investment grade corporate names, hit a peak of 1,173 basis points in March this year, since when it has just about halved, reaching 587 basis points at yesterday’s close.
Whether or not the worst of the credit market worries are behind us is a million dollar question, and one I’m not going to speculate on here. But what is interesting to look at is the performance of ETFs offering exposure to credit during the period and ask which have done best and why?
There are two ways of gaining corporate credit exposure in the European ETF market, one via corporate bond ETFs, the other through “pure” credit ETFs, whose value is linked to one of several credit derivatives indices.
Corporate bond ETFs will give you exposure not only to credit spreads (the excess interest rate paid on corporate bonds over government issues), but also to interest rate or duration risk (the longer the average maturity of the bonds in the index, the greater the sensitivity to changes in interest rates). ETFs based on credit derivatives give you exposure to credit spreads only, but there may be “roll yield” effects to deal with as the underlying indices typically “roll” into a new benchmark, containing a new series of underlying credit derivatives contracts, every six months.
So how have the relevant ETFs within the European market performed?
The chart below shows the NAV history of the three largest corporate bond ETFs in Europe (all offered by iShares), tracking euro, sterling and US dollar issues, since the beginning of March. All NAVs have been rebased to 100 on 27 February.
As I wrote a few months ago, the iShares sterling and US dollar corporate bond ETFs both have a higher average duration and greater exposure to financials than the euro ETF, and that has aided their performance over the last few months. However, the reverse was true in the previous six months, with the euro corporate bond ETF doing much better between September and March.
Overall, it’s been a great period for the holders of these funds. The sterling bond ETF, in particular, has climbed over 20% in price since late March, a performance that is more equity- than bond-like.
How have ETFs based on credit derivatives indices performed by comparison?
The next chart shows the performance of four funds within the credit sector over the same time period and on the same scale as the corporate bond ETF comparison. Again, ETF NAVs have been rebased to 100 on 27 February.
The EasyETF iTraxx crossover index ETF stands out, having gained around 15% over the period under review. This is because it offers exposure to the “junkier” corporate borrowers in Europe, and they have benefited most from the recent easing in credit conditions. The broader iTraxx Europe index ETF offered by db x-trackers (who also manage funds based on the Crossover and iTraxx HiVol indices) has performed much more sedately, adding only 4% since March.
The two other ETFs in the chart, db x-trackers’ funds offering exposure to senior and subordinated financial debt, have made gains, although not to the same extent as the Crossover ETF. At first glance this seems surprising given the rollercoaster ride that bank stocks and bonds have been on, but the underlying credit spreads in both bank debt indices are lower, on average, than those on the Crossover index components. As one might expect, the riskier subordinated debt ETF has performed better in a rising market than the ETF tracking financials’ senior debt.
The performance of corporate bond ETFs relative to “pure” credit ETFs over recent months has been helped by technical factors as well. Following the autumn panic in the markets, a large “basis” opened up between corporate bonds and credit derivatives (CDS) on the same company names, meaning that it was possible to buy a bond, hedge it with a CDS contract and lock in a profit. In other words, corporate bonds became very cheap relative to CDS, and the very large inflows we’ve witnessed in corporate bond ETFs over the first half of this year may well be partly due to this factor. That anomaly has now largely disappeared.
Conditions in the credit markets have been key in determining the overall health of the financial markets and credit indices have tended to give advance warning of equity trends, so the performance of all these funds is worth watching. It’s also good to see that European ETF investors have an ever-wider range of funds available through which to express views on this important sector.