High-Yield ETFs: Be Sure to Understand the Risk
November 19th 2012 at 10:32am by Matt Tucker -- iShares Head of Fixed Income Strategy
Much has been written about today’s prolonged low interest rate environment and how it has prompted many investors to seek out riskier assets in an attempt to generate a return that exceeds inflation. One big beneficiary of this trend has been high yield. This year through the end of September, $38 billion has flowed into high yield mutual funds and ETFs.
Most investors are aware that high yield bonds have greater credit risk than many other fixed income sectors. But what might be less appreciated – especially by investors who are new to high yield — is how challenging high yield liquidity can be at times, and how rapidly high yield bond prices can fall in a deteriorating market. [High-Yield ETFs Getting Junkier?]
Take a look at the chart below. It’s a six-month snapshot of the 2008 financial crisis, and it illustrates how bid/offer spreads on high yield bonds may widen as the market deteriorates. The dark blue line shows the market value of the Barclays US Corporate High Yield Index. The light blue line shows the average bid/offer spread of bonds in the high yield market. Notice how the market sell-off was accompanied by rising transaction costs for high yield securities.
Investors also need to understand the high yield market’s “equity-like” characteristics. For instance, when high yield sells off, it tends to do so in a “risk-off” market in which other higher risk investments, like equities, are also selling off. This drop in value during a stock market decline can be an unwanted surprise for investors who expect the bond portion of their portfolio to rise in value during a risk-off market and to help shelter the overall portfolio from the impact of a market dislocation.
Let’s look at two examples of this kind of dislocated market: the 2008 financial crisis and the US Treasury downgrade in August 2011. Over the past five years (October 2007 – October 2012), the correlation between high yield and the S&P 500 has been approximately 0.62.* However, during the onset of the financial crisis from 9/15/08 – 10/15/08 this correlation increased to 0.79. More recently, in the aftermath of the US Treasury downgrade during August 2011 the correlation jumped to a whopping 0.97 – meaning that high yield and equities were moving almost in lockstep with one another.
What does this mean for investors? High yield can be a good asset class for building yield into a portfolio, but it does not have the same diversification properties that are often looked for in a bond investment. This is especially true during falling equity markets when such diversification may be desired most. This is not to say that investors should shun high yield as an asset class. Indeed, any higher yielding asset is likely to exhibit similar behavior. Rather, investors should set realistic expectations for yield targets and obtain that yield from diversified sources (e.g., high yield bonds, EM bonds, dividend stocks, long duration US Treasuries or corporates).
In the end, yield is never free. It is just a question of what risks an investor wants to take and how they construct their portfolio.
*Correlations were calculated using daily observations between the market price of iShares iBoxx High Yield Corporate Bond Fund (NYSEArca: HYG) and the S&P 500.
Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy.