Much has been written about the evolution of financial markets over time. The flexibility of the system, diverse geographic access to markets, and the variety of investment options all contribute positively to investor choice. This provides small investors with many tools to effectively manage their portfolios to reach investment objectives. With all the progress made with the system and security choices, regulatory roadblocks to success continue to lurk.
Take a hypothetical couple, the Smith’s, for example. The Smith’s have accumulated over $750,000 toward their retirement. As the Smith’s near their target retirement date, traditional portfolio theory suggests the risk profile of their portfolio shift from a more aggressive allocation toward stocks to a more defensive position tilted toward income producing assets such as bonds. The goal would be to lower the risk profile of the portfolio while focusing on income production in retirement. The Smith’s would like to allocate an increasing portion of their portfolio into the high yield bond market during this transition. The problem is that only a fraction of the high yield market is accessible to the Smith’s. Using the Bank of America Merrill Lynch High Yield Index (BAML HY) as a proxy for the market, only 35% of the high yield market is directly accessible.
The roadblock for the Smith’s and other small investors is found in SEC Rule 144a. Rule 144a is an exemption to existing regulations that require securities to be registered with the SEC prior to issuance. Companies who use this exemption typically cite decreased time-to-market, cost, and documentation requirements as advantages. The unintended disadvantage to small investors, including the Smith’s, is these securities may only be issued to accredited investors or Qualified Institutional Buyer’s (QIBs). The spirit of the rule indicates a QIB must be an institution with more than $100 million in assets. Looking at the impact of the 144a exemption on the high yield market overtime paints a challenging picture for small investors.
Near the end of the Global Financial Crisis (GFC) on December 31, 2008, the BAML HY index was comprised of approximately 875 issuers from 18 broad sectors for a total face value of approximately $748bn (Exhibit 1). At that same point in time, the proportion of the BAML HY index that was classified as non-144a was $591bn, or over 80%. The proportion of the investable universe available to non-QIBs, and the Smith’s, was still reasonable.
Jumping forward to June 30, 2021 (Exhibit 2), the BAML HY index has more than doubled in size to $1.52tn, even though the number of issuers increased modestly to approximately 920. The investable universe available to the Smith’s and other non-QIBs has shrunk dramatically. Only 35% of the market value and 25% of the issuers are available. Perhaps more concerning, during 2021, a record 85% of high yield issuance volume has been issued under rule 144a. If this pace continues, small investors will likely have materially fewer options in the years to come.
Looking at the issue the Smith’s face from another perspective, let’s assume the Smith’s would like to gain exposure to the healthcare sector using one of the top 10 issuers in the BAML HY index. Tenet Healthcare Corp (THC) may be a potential fit. THC is a public company and files publicly available financial information whose stock is available on the NSYE. The Smith’s can access the riskiest part of the company’s capital structure, its common stock, whose volatility is approximately 2.2 times greater than the volatility of the SPX Index. Given their age, risk tolerance, and yield focus, they are more interested in the company’s debt securities. Despite the company’s operational improvement as indicated by positive credit outlooks from all three nationally recognized statistical rating organizations (NRSRO), their unsecured credit rating of Caa1 is only 2 notches above default at Moody’s. This is too risky for the Smith’s. The company has senior debt rated 3 notches higher at B1 by Moody’s that also has the added benefit of a security interest in certain assets as well as covenant protections. Unfortunately, the Smith’s cannot access these securities since they were all issued under the Rule 144a exemption. The Smith’s could buy the riskiest security from the company in the form of equity, but cannot access the higher quality, fixed income securities.
While we are not securities attorneys or market regulators, we believe a potential solution to the Smith’s issue could be a relaxation of the 144a Rule for issuers who file public financial statements and are subject to SEC filing requirements. If small investors can purchase a company’s riskiest securities, intuition suggests, they should be able to purchase the company’s lower risk instruments as well.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
S. Brad Fush, CFA
Executive Vice President, Director of Credit Research
Boyd Watterson Asset Management, LLC