High-yield, junk bond exchange traded funds allow investors to easily and quickly access the speculative-grade debt market, but these popular fixed-income ETF plays come with their own risks.
Junk bonds are expensive to trade and more likely to be mispriced, compared to other more heavily traded securities in more liquid markets, writes Alex Bryan, director of passive strategies research at Morningstar.
The junk bond market is notoriously known for its illiquid nature. Consequently, as index-based bond ETFs tries to reflect this illiquid market, popular plays, like the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) and the SPDR Barclays High Yield Bond ETF (NYSEArca: JNK), the two largest high-yield corporate bond exchange traded funds by assets, attempt to work around the liquidity issue by focusing on the largest and most heavily trade debt securities and weighting them by market capitalization. However, weighting methodology will steer investors toward the most heavily indebted issuers, which may raise credit risks.
Both JNK and HYG implement screens for liquidity to diminish indirect transaction costs associated with trading less liquid assets, such as wider bid-ask spreads. To qualify for inclusion in the Bloomberg Barclays High Yield Very Liquid Index, which JNK tracks, debt securities have at least $500 million in par value outstanding, are among an issuer’s three largest bonds, and issued less than five years ago. HYG’s underlying index, the Markit iBoxx USD Liquid High Yield Index, also requires holdings to have at least $400 million in par value, and the debt issuer must have at least $1 billion in total debt outstanding. Due to their similar focus on liquidity, the two high-yield bond ETFs have similar portfolios.
“All else equal, expenses would likely be the deciding factor in choosing between the two. This would tip the scale in favor of JNK,” Bryan said.
JNK has a 0.40% expense ratio and HYG has a 0.50% expense ratio.