April 2022
Where do investors turn to for income in an inflationary environment? Developed economies are carrying massive debt, and interest rates, while minimally rising, might not be enough to counter an inflation rate of nearly 8%.1 Given that backdrop, it is little wonder investors are looking outside the usual avenues for their returns.
One option is the high-yield bond market, specifically the U S high-yield bond market, which continues to grow. In 2021, U.S. high-yield bond issuance rose to US$429 billion, up significantly from the pre-pandemic level of US$253 billion in 2019.2
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 4.78%,3 defaults, if not mitigated, can pose a risk in a passive strategy—although the US high-yield trailing 12-month default rate finished 2021 at 0.3%,4 its lowest level since 2001.
Are there ways to mitigate these risks? The evolution of the ETF market, for example, 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, and the ETF vehicle itself, are making an asset class that was once the purview of pure active managers, more accessible.
1 Trading Economics data; accessed March 2022.
2 Debt Explorer data; accessed March 2022.
3 Y Charts.com data; accessed March 2022.
4 “U.S. high-yield default rate hits lowest on record,” Fitch Ratings, February 2022.
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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.
Risk
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.
Definitions
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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