Investors have been avoiding riskier parts of the credit market for most of 2008 as concern mounts about inflation and a slowing economy.
High-yield bond exchange-traded funds have been especially hard hit. For example, the iShares iBoxx High-Yield Corporate Bond ETF (AMEX: HYG) was down 1.2% this year heading into Wednesday. That compared to a 0.39% rise by the total bond market ETF iShares Lehman Aggregate Bond index (NYSE Arca: AGG).
The performance of high-yield bonds, or junk, also lags investment-grade corporate issues. The most popular of those higher-grade ETFs is the iShares iBoxx Investment Grade Corporate Bond index (NYSE Arca: LQD). Its returns were down 0.75% in 2008.
But such underperformance by junk bonds reflects a trend that began last spring when credit markets started feeling the impact of a meltdown in mortgages. In fact, junk bond funds have been doing better against their rivals lately as investors start to bottom-fish.
In the week of June 5-12, HYG gained 0.50% while AGG fell 0.71%. That period started the trading day before oil made a nearly $11-a-barrel jump on June 6 and disappointing economic data pointed to rising unemployment numbers.
"Earlier this year, Treasuries were the big outperformers," said Phil Fang, a fixed-income portfolio manager at Invesco PowerShares. "Within the past month, that trend has really started changing."
Simply put, in good times and bad, junk bonds are a different breed of bond ETF. That makes them a favorite of long-term asset allocators. And lately, some portfolio managers are arguing that an extended sell-off makes junk more attractive as a diversification tools these days.
Allocation Decisions
"High-yield bonds are a really interesting allocation decision right now," said Thomas Anderson, research director at State Street Global Advisors. "If you look at fixed income, Treasuries have been really overbought for most of this year."
SSgA came out with its own junk bond ETF at the end of last year. The SPDR Lehman High Yield Bond (AMEX: JNK) has lost just shy of 2% this year. Since coming on the market in December 2007, JNK has attracted $405.78 million in assets - all but about $18 million coming in the first half of this year.
The third competitor in the field is the Invesco PowerShares High Yield Corporate Bond ETF (AMEX: PHB). It also launched in December 2007 and has about $14 million in assets.
HYG is the oldest in the group at 14 months. With a nearly eight-month jump on its other two rivals, the ETF has garnered a sizable asset lead at $797.3 million.
"A year ago, investors weren't getting paid a ton more than Treasuries for taking more credit risk with high-yield bonds," Anderson said, noting that in mid-2007, junk bond funds were yielding around 7%.
Since then, an eight-month rush to quality by investors fleeing to Treasuries sent high-yield bond prices tumbling. At the same time, funds focused on junk took advantage as income streams took off.
"That's why the spread has widened [between junk and Treasuries]," Anderson said. "If you're looking at yield, there's just not many other places to go in today's market than high-yield bonds."
Advisor J.D. Steinhilber agrees. But the Nashville, Tenn.-based portfolio manager is still not ready to take a leap of faith on junk-bond ETFs yet. "They've definitely come back on my radar screen," Steinhilber said. "But I'd like to see their yields above 10% before shifting any allocations."
And he isn't alone. Several other advisors say they're taking a wait-and-see attitude, preferring to get a better feel for how much more of a slump the U.S. economy might be facing.
SSgA's Anderson, while a proponent of junk bonds over longer periods, admits that defaults in corporate bonds are bound to go up. But he argues it's not at alarming levels yet. According to the data he follows, defaults in 2007 hit all-time lows at 0.3%.
Default rates are expected to go up to a little over 2% this year and around 6% in 2009, Anderson adds. But those forecasts are based on estimates that the U.S. economy will keep weakening through next year.
Against that backdrop, it's probably worth noting that all three ETFs land in the top tiers in terms of credit quality of their portfolios, investing little in C-rated bonds. But PHB's is slightly higher right now than the other two with an average from Moody's of B1. Meanwhile, HYG and JNK are rated at B2.
The trade-off is that a little lower credit quality can translate into greater yields. Consider that JNK's 30-day SEC yield is about 9.81%, HYG's at 9.2% and PHB's running around 8.04%.
Longer term, of course, the major differences between the trio will come down to the makeup of their respective benchmarks.
PHB uses a high-yield bond index provided by Wachovia Capital Markets. It's an equal weight index consisting of the 50 most liquid securities that's rebalanced quarterly. The portfolio is broken into 31 different sectors. The largest of those now consists of integrated telephone companies, representing about 10% of the total index. Cable television stocks are the next biggest at around 8%, according to Fang.
Bolstered Performance?
In a junk bond market where many sectors are highly illiquid, Fang argues that PHB's long-term performance should actually be bolstered by its smaller number of individual holdings and emphasis on selecting only the most liquid issues in the market.
"It's very well-diversified across market sectors and all securities have to meet minimum trading volume and liquidity guidelines," he said.
In the case of JNK, it's using a more widely followed benchmark. But rather than using the Lehman Brothers High Yield index and its 1,500-plus bonds, SSgA has opted for a smaller version. That's the Lehman Brothers Very Liquid High Yield Index.
"The challenge is that the broader index has a lot of illiquid components," Anderson said. "So we indexed JNK to one that boils the market down by liquidity to about 100 different components."
The Lehman benchmark is a traditional market-cap-size-weighted index. It's heavy into industrials (78%) and charges the least of the three with an annual expense ratio of 0.40%. (Both HYG and PHB charge 0.50%.)
HYG tracks the iBoxx U.S. Dollar Liquid High-Yield index. It breaks the market into five broad categories: consumer services (25%); utilities and energy (19.98%); industrials and materials (19.8%); telecom and tech (14%) and consumer goods (9.4%).
The ETF also holds about 100 issues that it considers the most liquid and weights those by market-cap size.
But like the other two junk-bond ETFs, by avoiding illiquid parts of the market, HYG courts more volatility than broader indexes. Part of that relates to more concentrated portfolios.
The other aspect is that dealing with the most liquid junk bonds means underlying securities tend to trade more, says Matthew Tucker, head of investment strategy for fixed-income at Barclays Global Investors. "So there will tend to be more price movement in the short term," he said.
BGI, which sponsors the iShares ETFs, says the more concentrated iBoxx index's long-term performance tracks very closely with its broader benchmark as well as Lehman's and others. "There's a trade-off. The more liquid securities in the market tend to be of higher credit quality and generally come with less risk," Tucker said. "But the more liquid an index, the more it tends to have lower yields than the broader market."
