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Why you should rethink joining the high-yield ETF boom

Ten years of booming growth pushed global assets under management in high yield bond ETFs past $51bn (€42.6bn) in 2016, but are the apparent diversification benefits everything they’re cracked up to be?



Louise Hill

In yet another example of how the tentacles of the global financial crash slithered into every aspect of the financial world, the subsequent bottoming of interest rates and loose monetary policy following the crisis was a key cause of the high-yield boom over the last decade.

Desperate for yield and income, investors convinced themselves trading off heightened risk for higher returns was worth a go, even more so when it’s available through everyone’s favourite low-cost and passive vehicle, ETFs.

High yield = high cost

A Morningstar report, High Yield Bond ETFs a Primer on Liquidity, has noted the favourable macro backdrop encouraged issuers of high-yield bonds to increase issuance and extend debt maturities.

“This likely allowed for the survival of a number of financially unworthy credits,” wrote Jose Garcia-Zarate, senior ETF analyst at Morningstar.

“Irrespective, the net result was a significant decline in the rate of defaults for high-yield bond issuers, which in turn further fed the demand for the asset class.”

The problems arise when the ETFs by which people choose to access the assets are neither low-cost or passive.

Kames Capital’s high yield bond expert Stephen Baines points to the fee charged on two such high yield bond ETFs, iShares iBoxx $ High Yield Corporate Bond and SPDR Bloomberg Barclays High Yield Bond ETF, as similar to fees charged for active funds.

“Unlike most equity ETFs which are available for a few basis points, the leading high yield bond ETFs charge management fees which are comparable to many actively managed funds,” he says.

Passive or active?

To add insult to injury, high yield bond ETFs are not even truly passive.

Baines argues the market is simply too big to track.

“No one can be passive in the high yield market because it is constantly changing, the S&P and Dow Jones are static but with high-yield markets there are always new issuances and new companies coming and going,” he says.

He adds: “They have been quite bad at tracking the index because there are about 3,800 listings and ETFs ignore about 2,000 of those, they only own perhaps 1,000. So, they are not replicating the full index and that’s an active decision.

“This means these ‘trackers’ have taken an active decision to ignore hundreds of securities, leaving behind plenty of opportunities for active managers.”

High debt emphasis

A key flaw that should also be raised with investors hankering after one of these ETF products, is the emphasis the index has on the companies with the biggest amount of debt.

There could be a danger investors confuse equity trackers where the biggest weightings are in the biggest and most successful companies with high-yield indices, where the biggest weightings are firms with the largest debt burdens.

“Index funds are continuously forced to reallocate capital from improving credits where companies are reducing debt to deteriorating credits and companies increasing debt. To us, this is a highly illogical way of managing a credit fund,” Baines adds.