Raymond Kerzérho June 11, 2019 Market Research Spotlight on high-yield bond ETFs Given the meagre interest rates paid by investment-grade bonds and GICs, it is only normal that people are interested in investments with a higher return. That includes advisors, as high-yield bond (HYB) exchange traded funds (ETFs) offered by BMO and iShares alone hold over $2 billion in assets. That’s not chicken feed. Pension funds also focus increasingly on high interest investments, via private loans. So advisors aren’t crazy! What are high-yield bonds? HYBs are bonds with a “speculative” credit rating, that is, a rating lower than BBB- (Standard & Poor’s) or Baa- (Moody’s). An HYB may have been issued with a speculative rating (“vintage”) or have become speculative following a downgrade (“fallen angel”). The reason HYBs are stuck with the “speculative” label is the risk of default. Whereas securities rated AAA or AA very seldom fail (an exception being the non-bank, asset-backed commercial paper (ABCP) crisis in 2007-2008, when a number of AAA-rated securities defaulted), the probability of default increases exponentially below BBB/Baa. I should point out that the “high yield” category itself comprises different risk levels. Securities rated Ba have a “substantial” probability of default, B-rated securities have a “very substantial” probability and Caa-rated securities are considered to be verging on financial distress, as shown in Table 1. Table 1: Annual default rate by credit rating, 1920-2015 Source: Moody’s Investors are compensated for the risk they run with high-yield bonds. U.S. statistics show that historically, for the overall market, defaults have cost around 2.5% annually. HYBs, however, have paid an average premium of 5.3% compared with Treasury bond interest rates. Table 2: U.S. HYB market — Annual losses due to defaults, 1982-2015 Source: Moody’s Table 3: U.S. HYB index credit spreads, 1986-2018 Source: PWL Capital, Morningstar Interest rate risk Like government bonds, HYBs are sensitive to general interest rate movements. They are also hypersensitive to credit risk, which means that during recessions, widening credit spreads make HYBs shed a great deal of value. Equity bear markets are dark days for HYBs, as illustrated by Table 4. It shows that, roughly speaking, HYBs followed the same trend as stocks during the 2008 financial meltdown. Table 4: Value of $100 invested from January 2008 to March 2009 (in US dollars) In addition, a large proportion of HYBs are redeemable at par a few years before their maturity. That means that when interest rates decline or credit spreads shrink, the increase in value of HYBs is limited by this redemption privilege, as the issuer has the option of buying back the bonds before maturity. Experts call this “negative convexity.” In short, when the creditworthiness of the issuer deteriorates, the investor loses heavily; however, when the company’s situation improves, gains are limited. High-yield bond ETFs It goes without saying that holding individual HYBs is strongly discouraged, as the risks are huge and the potential gains are limited. That’s where exchange traded funds come in. Some ETF portfolios hold securities of hundreds of issuers, eliminating the risk of a single security or handful of securities in difficulty jeopardizing the investor’s portfolio. In addition, certain HYB index ETFs, such as BMO High Yield US Corporate Bond Hedged to CAD Index ETF (ticker: ZHY) or iShares U.S. High Yield Bond Index ETF CAD-Hedged (ticker: XHY), hedge the exchange risk inherent to the fact that most high yield bonds are denominated in U.S. dollars. Pros One of the things that makes high-yield bond ETFs popular is their high income. ZHY bonds’ yield to maturity is 6.33% (as of May 24). Once the 0.62% management fee is subtracted, investors are left with a substantial 5.71%. The numbers are similar for XHY. Another common argument in favour of high-yield bond ETFs is diversification. The correlation between HYBs and U.S. equities is 0.64, which suggests that adding HYBs to a portfolio of stocks and investment-grade bonds lowers volatility. Cons I don’t really agree with the diversification argument. To measure HYBs’ contribution to portfolio stability, I ran a Fama-French three factor regression analysis of the credit premium of a well-known U.S. HYB index. I found that the 68% of the credit spread may be explained by stock market fluctuations, fluctuations in the value premium and fluctuations in the U.S. equities size premium. In addition, the regression alpha is negative (-0.13% per month) but non-significant from the statistical standpoint. In short, the HYBs’ performance is mostly explained by the behaviour of stocks and investment-grade bonds. We can track an HYB portfolio with 40% equities and 60% investment-grade bonds. Table 5: Fama and French analysis of credit spread for high-yield bonds, 1995-2018 Alpha Market (beta) Size Value R-squared Sensitivity -0.13 0.42 0.17 0.13 0.68 t-statistic -1.01 13.7 4.1 3.0 Source: PWL Capital Another reason to think twice about investing in HYBs is high fees. Most high-yield bond ETFs listed in Canada have a management expense ratio (MER) of over 0.60%, which means an equivalent reduction in the investor’s return. Finally, my research led me to understand that HYB indices are hard to track, even for the most experienced professional managers. For example, SPDR Barclays Capital High Yield ETF (listed in the United States), a leading high-yield bond ETF, posted a return 1.44% lower than its benchmark index over 10 years, while its MER is just 0.40%. The tracking error has been smaller for the past three years, but the long-term figures are uninspiring. Table 6: Relative performance of SPDR Barclays Capital High Yield ETF (March 31, 2019) Return in US$ 1 year 3 years 5 years 10 years ETF 5.48 6.18 2.75 7.86 Index 5.51 7.04 4.40 9.30 ETF minus index -0.03 -0.86 -1.65 -1.44 Source: Morningstar Conclusion If you are absolutely set on generating high income in Canadian dollars, you can add HYBs to your portfolio, but only via a diversified investment vehicle hedged against the foreign currency risk. ZHY and XHY will probably do the job. But beware: your high-yield bond ETF will have a rough ride during bear markets. However, if your goal is simply to diversify your portfolio in order to mitigate fluctuations, HYBs will be of only marginal assistance. Personally, I think that allocating 40% to a stock ETF and 60% to a low-fee, investment-grade bond ETF will essentially reproduce the long-term behaviour of an HYB index fund, but with a higher expected return. Last but not least, I don’t think that active management resolves the difficulty of generating good returns with HYBs. A statistical study published by Standard & Poor’s showed that from 2008 to 2017, 84% of HYB mutual funds and 81% of HYB institutional funds were unable to outperform their benchmark index, even gross of management fees. Share: Facebook Twitter LinkedIn Email CIRO Advisor Report
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