High Yield (i.e. non-investment grade corporate debt) was one of the most notable success stories in the European fixed income ETF market in 2010, and judging by market flows data for the first two months of 2011 sourced from Morningstar Direct one can confidently say that the good times continue. Indeed, EUR-denominated High Yield Bond ETFs saw estimated net inflows of EUR 202 million in the January-February period, comfortably gaining this particular ETF segment the accolade of best performer in the European fixed income ETF category. During the same period, EUR-denominated government bond ETFs saw net outflows of just over EUR 1.3 billion, which put them right at the opposite side of the popularity scale.
The flows data for EUR-denominated High Yield ETFs are nothing short of remarkable if one takes into account that the current offering is made up of just two ETFs, as opposed to the around 90 ETFs offering exposure to the eurozone government bond market. Besides, the market story of the High Yield ETFs is measured in number of months rather of years. The physically-replicated iShares Markit iBoxx Euro High Yield Bond (IHYG) came to the market in early September 2010, while the swap-replicated Lyxor ETF iBoxx EUR Liquid High Yield 30 (YIEL) made its debut in mid-January 2011. As of end March 2011, the iShares High Yield ETF (total expense ratio of 0.50%) had attracted assets of just over EUR 600 million, while the Lyxor vehicle, charging a lower TER of 0.45%, lagged with assets a touch below the EUR 40 million mark.
As it often happens in the ETP market, whoever comes in first to fill a void tends to take the lion’s share of existing demand, with competitors generally left to claw market share either by competing in cost terms or by offering some kind of innovation versus the incumbent dominant provider. By the end of its first two months in the marketplace, the iShares ETF had managed to amass some EUR 323 million in assets. The EUR 40 million taken so far by Lyxor looks small by comparison. However, it would be unwise to draw any firm conclusions just by looking at AUM data. We are talking about an ETF provider challenging another with a monopolistic grip. The success story for the Lyxor High Yield ETF will be primarily measured by whether it manages to capture enough market share to make it self-paying, rather than by whether it debunks iShares from the top spot.
Judging by recent flows data, the omens for Lyxor do not look too bad in principle as money has been flowing thick and fast to High Yield ETFs. The reason for this positive trend is simple to understand: returns. In contrast to the negative first quarter performance from eurozone government and corporate bond ETFs, with average returns of -1.24% and -0.73% respectively (note: returns data refers to ETFs offering exposure to the broad maturity spectrum), the High Yield ETF category has done well.
Performance data sourced from Morningstar Direct shows that the iShares High Yield ETF returned 2.28% in Q1-11 and around 5.40% since inception in September 2010. Meanwhile, since inception in mid-January, the Lyxor High Yield ETF has posted positive returns of 0.59% out to end Q1-11. For the benefits of comparison, the iShares ETF posted returns of 0.64% over the same period. We would argue that the difference in returns between the two ETFs is mostly a function of the different exposure they provide to the High Yield Bond universe, with the iShares ETF replicating the performance of a broad index while Lyxor has opted for an index restricted to the 30 most liquid securities.
If ever there was an occasion to stress the importance of understanding indices this is it. Here we have two ETFs marketed as offering exposure to the same market, but tracking two different indices from the same index provider. As a result, the exposure investors ultimately gain is different and so will be the returns. As an aside but also very important, non-eurozone investors should be aware of foreign exchange implications as both these ETFs are EUR-denominated. UK investors in particular should also make sure to ascertain whether any non-UK domiciled ETP they buy into has been granted UK reporting status as this has significant implications for taxation purposes.
The success of the High Yield ETF category has been facilitated by a happy confluence of events on the demand side of the market equation, which, at least on paper, would look mutually exclusive. On the one hand, the investor community as a whole has turned less risk averse in nature as the economy, despite pending question marks, is judged to be well on a growth path. This is bound to benefit notional high risk categories such as non-investment grade corporate debt. On the other hand, High Yield has also benefitted from increased demand from risk-averse money flows, now seeing inflated government debt as a more perilous proposition than corporate debt. In sum, we see two opposing investment rationales sharing a common objective and thus providing the basis for solid demand.
However, solid demand, while important, is only part of the story. The conditions on the supply side have played a key part. Despite improving economic conditions, traditional lending channels remain severely impaired. Corporations, particularly small- and mid-cap, which before the crisis met the bulk of their borrowing needs by means of bank loans, now have to make recourse to the open market. In short, supply has also increased. The end result is something of a parallel shift on both sides of the supply-demand equation which is keeping premiums and dividend income broadly in check.
All of the above bodes well for High Yield ETFs at a time when investors are very keen to boost overall returns against the backdrop of a low yield environment. However, one can only wonder whether the confluence of events behind the current success story will be long lasting. It would be unwise to expect bank lending to remain impaired forever. Equally, chances are that risk perceptions on sovereign risk would eventually normalise. But until that happens, High Yield may continue to do well. As such we welcome the ETF industry for opening up the access barrier to this asset class for all investors.
