There’s been much ado about high yield bond ETFs in the media for a while now. And with good reason – after a six month stint as the asset class of choice for yield-hungry investors, these funds have been riding a roller coaster of late, making headlines for everything from large redemptions to record trading volume.
With the story changing almost weekly, I think it’s a good idea to step back and ask a more fundamental question: what role does high yield play in an investor portfolio?
It’s an interesting question, particularly because with the introduction of high yield ETFs investors now have a new way of accessing the market. High yield ETFs have brought liquidity, transparency, and access to a market that was previously opaque and difficult to access for many investors, and today have grown to thirteen funds and $26 billion in assets globally. Choice is a good thing, but as always investors should consider their own portfolio needs before investing in any asset class or sector.
So what are the considerations for investing in high yield bonds? The obvious attraction is yield, particularly for income seeking investors battling with a prolonged low interest rate environment. The iShares iBoxx $ High Yield Corporate Bond Fund (NYSEArca: HYG) has a 30-Day SEC yield of 6.65% (as of 7/9/12). However, it’s important to note that this yield comes at a price – namely, higher credit risk than most fixed income securities, and therefore a higher risk of default. It’s this perilous reputation that earned them the moniker “junk” bonds.
Despite the negative connotations, it’s important to remember that junk bonds are still bonds, and that means that they are generally less risky than equities (see below). This simple point is often misunderstood by many investors. High yield debt issuance has a higher claim on assets than equity issuance, which means that if a firm faces bankruptcy, the bond holders get paid before the equity investors. We’ve actually seen clients shifting their dividend-paying equity allocations into high yield for just this reason, as a way to reduce risk and boost income.
Of course, more risk also equates to higher expected returns. What’s interesting to me is how these different asset classes deliver return to investors. When an investor moves from Treasury bonds to investment grade corporates, they are taking on an increasingly high level of default risk and are being compensated with higher expected yields. When an investor goes from high yield to developed market equities they actually receive a lower expected yield but a higher expected price appreciation, which results in a higher expected return.
What’s the bottom line for how investors should think about high yield? As an asset class that offers some of the largest yields in fixed income markets high yield can play a role in generating income for a portfolio, but investors should be mindful of the increased risk relative to many other fixed income sectors. High yield’s best role is as a source of income in a broadly diversified portfolio.
Full disclosure: Tom Lydon’s clients own HYG.