I’ve spent the past few weeks looking deeper under the hood of the high-yield bond ETFs and the results might surprise you. They certainly surprised me!

Let’s first define what a high-yield bond is. It is a bond issued by a smaller, or riskier company, such that the company has to offer a higher interest rate to entice investors to loan that company money. High yield bonds are also commonly called Junk Bonds, though the industry tends to avoid that label, because who really wants to own “junk”?  We’re still talking about reasonably large companies who trade on the public stock markets. They might not all be household names. If they are, they’re likely to be very capital-intensive companies or companies that have fallen on hard times. Think of Sprint or T-Mobile in the US.

These are riskier bonds. To offset the risk that some of these companies might default, or go bankrupt, you’ll want to buy them by the hundreds. So, the higher interest rate you get, minus some presumed default rate on the pool of companies, is what you end up with as an investor at the end of the day.

Canada doesn’t have a particularly large or liquid market for high yield bonds. If you want to get any decent kind of diversification, you have to look to the US market. That said, I don’t particularly want to take currency risk on the income side of portfolios. So, I’ve always bought US high yield bond ETFs that are hedged back to Canadian dollars. These ETFs strip out the effect of the rise or fall of the Canadian dollar against the US dollar.

One of the reasons I’ve taken a closer look at these high yield bond ETFs is that they are one of the more expensive ETFs. At 0.6% to 0.7% MER, it’s important that you are getting value for the fees you are paying.

Another reason I’m taking a closer look at these ETFs is the tracking error relative to their underlying index. If you look at the iShares U.S. High Yield Bond ETF (CAD Hedged), you’ll see that it has underperformed it’s index by about 0.9% per year since it started trading in January of 2010. Now 0.7% of that underperformance is explained by the fee that is charged inside the ETF, but what about the other 0.2%? Over 10 years, that can add up. If you look at the equivalent BMO ETF, which is called the BMO High Yield US Corporate Bond Hedged to Canadian dollar ETF, the underperformance over almost 10 years amounts to 1.5% per year, leaving a whopping 0.9% of underperformance per year that isn’t explained by fees.

Unfortunately, this phenomenon isn’t only reserved for the Canadian-based ETFs that buy US high yield bonds. When you look at the large US-based ETFs that hold high yield, they suffer from the same magnitude of underperformance relative to their indexes.

Seeing this, it then begs the question: what should I replace these ETFs with in my portfolios?

High yield bonds are subject to the forces that move bond markets, like interest rate movements, but they are also subject to the forces that move stock markets. This makes sense: If a company’s stock is plunging, it most likely means there is something wrong with the future outlook for that company. As a result, it’s ability to pay the interest on its debt, or bonds, is likely compromised as well. That leads to a drop in the value of the company’s bonds.

So, I asked my director of research, Ray Kerzerho, to run some regression analyses on the most common high yield bond index, relative to the aggregate Canadian investment grade bond index and the US stock market index. A regression analysis shows us to what extent the movements in one index are similar to another.

It turns out that we can replace the high yield bonds in portfolios with a combination of 60% investment grade bonds and 40% stocks, and expect the same overall return, but with a little less fluctuation along the way. Investment grade bond ETFs and stock ETFs are much cheaper, and they track their indexes much more closely. This makes a winning combination.

This exercise is a good example of what proper portfolio management is, and is not, all about. Portfolio Management is not about picking the next winning stock, or timing your way in and out of the markets. It’s about capturing market returns as efficiently and at the lowest cost that you reasonably can.