February 20, 2020
Where do investors turn to for income? With global central banks utilizing all tools to keep rates suppressed and the mountain of debt trading at negative yields reaching more than US$10 trillion1, as of the end of 2019, that’s a key question. Given that backdrop, it’s little wonder investors are looking outside the usual avenues for their returns.
The case for a high yield ETF
One option is the high yield bond market, specifically the US high yield bond market, which continues to grow. Last year US high yield bond issuance rose to $253.2bn with the asset class seeing capital inflows in almost every month of 2019, reversing the trend seen in 2018.2 Meanwhile in the opening month of 2020, global high yield bond issuance hit a 25-year monthly record with global issuance reaching $73.6bn in January.3
High yield bonds typically offer higher coupons than investment grade corporate or sovereign bonds. Investors may also value the potential for diversification from equities or from their investment grade and sovereign peers. Third, the increase in issuance can create an improvement to underlying relative liquidity.
That’s not to say there are no downsides. It stands to reason that companies issuing high yield bonds have lower credit ratings than their investment grade peers and are generally considered to have a greater risk of default. Volatility can also be higher in the high yield space than with investment grade-rated corporate debt or higher-rated sovereign bonds.
For active managers the goal to match or exceed a US high yield index return has proved to be a challenge. Active managers face implementation hurdles such as higher trading costs, low liquidity, and difficulty in sourcing high yield bonds. At the same time, many investors do not opt for a straight passive approach in this market sector for similar reasons.
While an appealing part of the investment market, with an average yield to worst (lowest potential yield that can be received on a bond without the issuer actually defaulting) at 5.13%4, defaults – if not mitigated – can pose a risk in a passive strategy. The US high yield TTM5 default rate finished 2019 at 3.3%, its highest level in three years and although 2020 started with negligible defaults, expectations are it will rise this year.6
Are there ways to mitigate these risks? The evolution of the ETF market has seen some entrants strive to tackle the dilemma of high yield bonds, introducing options to help facilitate lower trading costs and add a measure of flexibility. Among these are the implementation of different trading options, such as a stratified sampling approach to help the investment team effectively manage turnover and transaction costs. Other tools may also be used to help mitigate some of the downside risks posed by the threat of defaults in the sector.
Combined, such trading techniques are making an asset class that was once the purview of pure active managers, more accessible in a tax-efficient and liquid vehicle such as an ETF.
1 Bloomberg. Bond World Is Backing Away From All That Negativity as 2019 Ends. December 23, 2019
2 Debt Explorer. High yield closes 2019 on top. January 21, 2020.
3 Source Dealogic, accessed February 17, 2020.
4 Bloomberg. Based on the Bloomberg Barclays US Corporate High Yield Total Return index. As at February 20, 2020.
5 A trailing twelve month yield - the percentage of income the fund portfolio returned to investors over the past 12 months.
6Fitch U.S. High Yield Default Insight (TTM Default Rate Remains Above 3%; Strong 2020 New Issuance). February 2020.
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ETF shares are listed on an exchange, and shares are generally purchased and sold in the secondary market at market price. At times, the market price may be at a premium or discount to the ETF's per share NAV. In addition, ETFs are subject to the risk that an active trading market for an ETF's shares may not develop or be maintained. Buying or selling ETF shares on an exchange may require the payment of brokerage commissions.
ETFs trade like stocks, are subject to investment risk, including possible loss of principal. The risks of investing in the ETF typically reflect the risks associated with the types of instruments in which the ETF invests. Diversification cannot assure a profit or protect against loss.
Investors may not invest directly in any index
Bonds are subject to interest rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines. High yield bonds involve increased credit and liquidity risk than higher rated bonds and are considered speculative in terms of the issuer’s ability to pay interest and repay principal on a timely basis.
Options: Conditional derivative contracts that allow buyers of the contracts (option holders) to buy or sell a security at a chosen price. Stratified sampling approach: An indexing method where the ETF portfolio manager divides an index into different buckets, where each bucket represents different characteristics of the index.
Past performance is no guarantee of future results.
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