The problems with high-yield bond ETFs

The problems with high-yield bond ETFs
Pexels/Anna Nekrasevich

Due to the huge growth in passive investing, there is now a tracker fund for almost every kind of investment, so it is no surprise that you can passively invest in high-yield bonds via a host of exchange traded funds. The question is: should you?

For investors seeking an above-inflation income, high-yield bonds currently look like an attractive option, as they are offering returns more aligned with 4 per cent to 5 per cent annually than the 1 per cent offered by investment-grade bonds.

High-yield bond ETFs also appear to offer capital preservation and a healthy level of diversification. If you wanted to invest passively, there is a wide range of options, including BB-rated ETFs and ‘Fallen Angel’ ETFs.

But just because ETFs for high-yield bonds exist, it does not mean it is a good idea to invest in them. In fact, there is certainly a case to be made that passive high-yield trackers are not doing what they say ‘on the tin’. In fact, they are consistently underperforming the benchmarks they purport to be tracking and their performance is widely misunderstood.

Problem number one: High-yield bond ETFs often underperform. Some of the dominant high-yield ETF funds have consistently underperformed over the past decade. Why? Well, the most important issue with attempting to track a high-yield corporate index is liquidity.  More specifically, each bond within the index has a limited amount of supply available to investors and, quite often, only a portion of that supply is actually available to buy or sell. This presents not only a challenge for active managers attempting to beat the benchmark, but for passive managers trying to replicate the benchmark. 

Problem number two: The fees on high-yield ETFs are higher than expected, so this drags on performance against the benchmark. A number of ETFs have an expense ratio of more than 0.4 per cent, which may sound reasonable compared with the charges made by equity funds, but in high-yield this exceeds the fees of many active mandates for institutional clients. 

Problem number three: Passively managed funds cannot navigate drawdown periods as effectively as actively managed funds. This is due to a number of factors, including: the passive alternative cannot utilise active security selection in raising cash to meet redemptions; plus, there is the inherent negative impact of transacting in a down market when liquidity is fleeting and transaction costs are high. Due to the increased volatility of flows in passive products relative to actively managed funds, particularly in times of stress, these punitive costs are often elevated for the ETFs.

Problem number four: Perhaps the most interesting problem – if you are invested in an equity index tracker, your tracker will be filled with the biggest businesses in that index. A high-yield bond tracker is weighted towards the biggest debtors. While being the biggest company may indicate success, and warrant inclusion on an equity tracker, being the biggest debtor has little correlation with success.

Of course, there is no denying that a high-yield bond ETF offers liquidity benefits for those investors who put liquidity above all else. But, if your goal is to capture high-yield performance as part of an investment portfolio, high-yield ETFs may not be the investment you are looking for.