The success story of EUR-denominated High Yield bond ETFs continues apace. Morningstar Direct estimated net flows YTD data to end-April place the iShares Markit iBoxx Euro High Yield ETF as the tenth most sought after ETP in the European market with net inflows of EUR 358 million, only surpassed by a collection of equity ETFs, with German large cap (e.g. DAX) featuring prominently. The much smaller (as measured in assets under management) Lyxor iBoxx EUR Liquid High Yield 30 ETF ranked 262 out of a universe of 1122 individual ETPs, with net inflows of EUR 14mn. Narrowing down the field of analysis to fixed income ETPs, the iShares vehicle was top dog, well ahead of the second most popular ETF for the period, the db x-trackers iBoxx Global Inflation-Linked TR Index Hedged which recorded net inflows of EUR 118mn. Meanwhile, the Lyxor ETF managed 32nd position out of 170.
Some two months ago in the article High Yield ETFs Popular in a Low Rate Environment we explained how the economic background borne out of the financial crisis has provided fertile terrain for the rapid growth of yield-enhancing ETPs. Demand for non-investment grade corporate bonds over the last two years has outstripped supply, even with the latter on a clear upward trend. As a result, yields have fallen from double-digit levels to around 6-7% on average at present, while credit spreads (i.e. the yield difference to creditworthy sovereign bonds) have compressed at a considerable pace (e.g. over the past year the average high yield credit spread has halved from a high of around 850bps). Despite the sharp decline in yields; levels around the 6-7% mark are still an attractive proposition in these times.
The article received a sizeable number of hits from our online readership, thus providing some anecdotical evidence of investors’ interest in this particular asset class. As a result, we feel there is good reason to do a follow-up piece, this time focusing on the two key practical issues of ETP selection and use within an investment portfolio.
Understanding the Index is Paramount in the ETP Selection Process
As we write, the EUR-denominated high yield bond ETP offering is restricted to the aforementioned ETFs marketed by iShares and Lyxor. And yet, this reduced market fully encapsulates one of the key issues ETP investors face, namely how different indices provide different levels of exposure to the same market. In this particular case, the situation is made the more interesting since the two indices used by iShares and Lyxor are produced by the same provider and their full marketing names are identical bar the number 30 at the end of one of them. It would be fairly easy to imagine a situation where investors fail to notice that we are dealing with two very different indices with different construction rules and therefore measuring the same market in two very different ways. We shall never tire of stressing how important it is for investors to analyse indices before putting money into an ETP. One of the risks of investing via ETPs is that of unrealised expectations by failing to understand what the index the ETP tracks is actually measuring.
The Markit iBoxx Euro Liquid High Yield index used by the iShares ETF as benchmark of reference measures the performance of EUR-denominated non-investment grade corporate bonds with a minimum outstanding of EUR 250 million, a minimum maturity of 2 years and maximum of 10.5. The index is rebalanced on a monthly basis. As of writing the number of index constituents was 202. Meanwhile, the Markit iBoxx EUR Liquid High Yield 30 index chosen by Lyxor restricts the universe of eligible bonds to 30, all issued by non-financial corporations and with a minimum outstanding of EUR 500 million. Another difference is that the High Yield 30 index is rebalanced on a quarterly rather than monthly basis.
The two indices share some common features (e.g. the statistical weight of an individual issuer within the index is capped at 5%), but the differences in construction rules are very significant. It could be argued that the “30” index would perhaps aim to capture the performance of the most liquid segment within the high yield corporate bond universe. The trade-off is one of potentially missed opportunities as the riskiest elements of the high yield bond universe would tend to compensate with higher yields. In fact, total returns data for the February-May sourced from Morningstar Direct for the two ETFs conveys this “opportunity cost” message, with the iShares ETF returning 2.57% vs. 2.21% for the Lyxor ETF (note – returns are annualised). Needless to say, the “opportunity cost” can easily turn into an advantage in a different environment. In sum, two indices, two different measures of the same market that will appeal to different investors’ risk profiles.
Core or Satellite Element?
Gaining exposure to the high yield corporate bond market is often thought of as a way to generate higher returns relative to better credits, though investors in this particular asset class will have to accept the trade-off of much higher notional risk vs. investment grade corporate debt. This means that expectations for a steady stream of income should be lower while the risk profile (e.g. default is not a rare occurrence in high yield) should be higher. Also, despite increased supply in the last two years and the decline in the rate of defaults, the fact remains that the high yield bond market is significantly less liquid than the investment grade corporate bond market, which may impact performance further down the line.
The decline in high yield bond defaults over the recent past has been instrumental in reshaping investors’ risk perceptions. However, it must be noted that this decline has come about as a result of a remarkable shift in the end-usage of corporate funding from investment to debt repayment/restructuring. Indeed, data from the Association for Financial Markets in Europe shows that 50-60% of funding via bond issuance in 2009-2010 was used for debt repayment and restructuring, up from 10-20% in the pre-crisis years. Default rates may remain historically low for some time to come as there has been a fair deal of debt restructuring with a lengthening of maturities beyond 2014. However, chances are that when the economic situation normalises, the rate of high yield bond defaults will tend to mean-revert.
In our view, the combination of a substantial yield pick-up and the notable risk profile means a high yield bond ETF would be best deployed as a satellite component of a fixed income investment portfolio, and probably one with a relatively small weight. Having said this, investors with a high tolerance to risk are likely to feel comfortable overweighting positions in a high yield bond ETF with the objective of boosting overall portfolio returns in the current environment. In fact, for this type of investor, a high yield bond ETF may not actually be a tactical bet but rather the preferred vehicle to meet the strategic need for exposure to the corporate debt market. In this particular case we could find a high yield ETF playing a core role in investment portfolios. However, we would see this as an exception only suited to investors with both a high tolerance to risk and sufficient financial muscle to manage potentially big swings in performance.
