A version of this article was previously published in the January 2020 issue of Morningstar ETF Investor. Click here to download a free copy.
The high yield bond market has always been one of the best markets for actively managed funds. Over the past 10 years to December 2020, 42.3% of actively managed funds in the Morningstar High Yield category survived and outperform the category average for passive funds, compared to 27.9% of active funds in the Morningstar High Yield category. category of basic intermediate obligations.
The main criticisms against passive investing in the high yield bond market relate to market liquidity (or lack thereof), pricing errors, and the merits of the market value weighting these types of issues. These considerations make active management the best avenue for exposure to high yield bonds.
Low fees are the best thing high yield bond indices offer them. Although high yield index funds are more expensive than most other types of index funds, they have a slightly greater cost advantage over their active peers than their counterparts in the investment grade intermediate core bond categories, Core Plus Intermediate Bonds and Corporate Bonds, as Exhibit 1 shows.
The expense ratio is the most obvious cost that investors pay, but it is not the only one. High yield bonds generally have limited liquidity, which can lead to high transaction costs for high yield bond index funds.
Liquidity refers to the ability to buy or sell a security quickly and easily without significantly affecting its price. When the securities are not traded very often or in high volumes, as is the case with most high yield bonds, the investor who wishes to trade them must offer a price concession for someone to take the lead. other side of the trade.
Transaction costs tend to be more pronounced among high yield bonds than among quality bonds. An article published by Pimco in August 2018 examined liquidity in the corporate bond market and found that the average cost per transaction was inversely related to the credit rating of issues. For example, transactions involving corporate bonds rated B + and below cost almost twice as much to trade as those rated BBB.
While every high-yielding market fund faces high transaction costs, the effects are more acute for index funds, as they are often forced to trade to match index changes, regardless of the impact on them. the costs. For example, a passively managed fund may need to sell an issue that is removed from the index to ensure that its performance remains close to the benchmark, but the lack of liquidity of the issue may cause the issue to fluctuate. of the price against the manager. An actively managed fund may not sell this issue.
The limited liquidity of high yield bonds can make it difficult to track high yield bond index funds. For example, in the five-year period to September 2021, the 36-month rolling average tracking error for index funds in the high yield bond category was almost 60% higher than the figure. correspondent for index funds in the corporate bond category. To reduce transaction costs and tracking error, the first generation of passively managed high yield bond funds limited their exposure to the most liquid bonds. IShares iBoxx $ High Yield Corporate Bond ETF (HYG) selects bonds with an outstanding par value of at least $ 400 million, while SPDR Bloomberg Barclays High Yield Bond ETF (JNK) requires bonds to have an outstanding face value of at least $ 500 million.
Although liquidity screening is pragmatic, these liquidity screening limits the exposure of these funds to the set of available opportunities. For example, the ICE BofAML US High Yield Constrained Index has a lower minimum liquidity threshold of $ 250 million per issue. More than 25% of its constituents, representing 12% of the index, came from issues of less than $ 400 million. Without fully seizing the full set of opportunities, JNK and HYG’s performance may diverge from that of their active peers, reducing confidence that their pricing advantage will translate into strong performance by category.
NAV / Premium / Reduction
The limited liquidity of high yield bonds can also cause high yield exchange traded funds to deviate from the net asset value of their holdings. It is often expensive for authorized participants (a special breed of market makers) to arbitrate these spreads because the prices quoted behind each fund’s NAV may be different from the prices at which they can trade. This is because the bid-ask spreads are wide here, many of these bonds may have stale prices, and APs may have to offer price concessions to entice others to trade the desired bonds. To make arbitrage worthwhile, a larger premium or discount is often required than for a quality bond ETF, as shown in Annex 2.
Premiums and discounts among high yield bond ETFs could be more of a red herring than a red flag. These ETFs are generally more liquid than their underlying holdings and often serve as the primary vehicle for price discovery.
The problem with market value weighting
In addition to the complications regarding the liquidity of high yield bonds, there are also concerns about the merits of the market value weighting in this set of opportunities. The main concern is the tilt towards the most leveraged issuers, although this is not as problematic as it might seem at first glance. After all, some active investors own each of these bonds in proportion to their market value. As such, the market value weight is the most accurate representation of the opportunity set. It takes advantage of the collective wisdom of market participants to determine the value of its securities, promote low turnover and minimize transaction costs. To the extent that larger issues are riskier, they should offer higher returns to compensate.
A stronger argument for active management concerns the poor valuation of the high yield bond market. There is more risk of bad pricing here than in the market for quality investments because there are fewer transactions resulting in less competition and less price discovery. For example, credit rating agencies may take time to update their ratings in response to changes in credit quality. Because these ratings influence bond prices, this slowness can create opportunities for more nimble investors.
There are also other pockets of inefficiency unique to the high yield market. For example, lower rated bonds can be overvalued by investors looking for yield. As shown in Figure 3, the lowest-rated bonds have historically delivered below-average risk-adjusted performance.
Conversely, “fallen angels” (issues initially rated as investment grade but which have since been downgraded) may be undervalued when downgraded below investment grade, as these downgrades often create forced sales. . Fallen angel investors tend to occupy the upper layers of the risk bond credit quality spectrum and are likely the catalyst for the strong performance of the Bloomberg US High Yield Ba Index.
Actively managed funds represent the best option for exposure to the high yield bond market. There are a handful of funds in the category with Morningstar analyst ratings for gold and silver, all of which are actively managed. To date, there is only one passively managed Morningstar Medalist in this market: the iShares Broad USD High Yield Corporate Bond ETF, rated Bronze. (USHY). All other index funds that we rate in this category are rated neutral. USHY benefits from low fees and a broadly diversified portfolio, but its Process Pillar rating currently sits at Average, reflecting the limits of indexing in this market. That said, there are some interesting high yield bond index strategies that are worth checking out.
Vanguard High Performance Enterprise (VWEHX) is one of the cheapest active high yield bond funds on the market. Its Investor share class charges 0.23%, less than many passive alternatives. Active stock selection and liquidity management are a plus. This fund effectively controls risk by focusing on bonds with high liquidity and underweighting lower quality high yield bonds.
BlackRock High Yield Bond (BHYAX) is more expensive (0.93% expense ratio) but is also worth considering, as it was upgraded to gold instead of silver in October 2019. It applies a flexible approach to selection securities, by adapting the risk to the level of remuneration offered by the market. Like Vanguard High-Yield Corporate, this fund tends to stick to the most liquid issues in the market, and its managers have the flexibility to trade in other segments of the market. For example, they may invest up to 10% of the portfolio in equity securities instead of CCC rated debt securities.
Some high yield index funds seek to mitigate exposure to potentially overvalued sectors of the high yield market and take advantage of inefficiencies. For example, the IQ S&P Low Volatility High Yield Bond ETF (HYLV) (0.40% expense ratio) favors low-risk, high-yield bonds, which have historically offered better risk-adjusted performance than lower-quality high-yield bonds because they are less likely to be overvalued by performance-oriented investors.
IShares Fallen Angels USD Bond ETF (FALN) (0.25% expense ratio) may allow investors to profit from the forced sale of bonds that are downgraded below investment grade. This index fund offers a large market weighted exposure (with an issuer cap of 3%) to these bonds. Over the past 10 years up to December 2019, the index that this fund tracks has beaten the broad ICE BofAML US High Yield Total Return index by 2.6 percentage points per year, while favoring higher quality bonds.
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