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.
However, JNK has shown a greater deviation from its underlying index and turn over has generated a slightly lower return over the nine-year period ended 2016 with greater risk, Bryan warned. Additionally, the SDPR offering includes a greater tilt toward more riskier speculative-grade debt rated CCC and below.
Bryan explained that HYG more closely tracks its underlying index as the fund accurately reflects the prices available to the fund – mew bonds are added to the index at the ask but are subsequently priced at the bid, which helps reduce the gap with its index, but this also reduces the index’s return.
“So it doesn’t lead to a real performance improvement, just better optics with respect to HYG’s tracking performance,” Bryan added.
Nevertheless, tracking error may not be a long-term factor as other characteristics like underlying holdings and credit quality may play a greater role.
“In the long term, tracking error shouldn’t have a significant directional impact on returns,” Bryan said. “So, the more important issue to focus on is JNK’s tendency to have greater exposure to the lowest-credit-quality bonds, which has made it a bit riskier than HYG. Those who can stomach this risk will likely be rewarded with slightly higher returns over the long term.”
While JNK and HYG have been the go-to for high-yield debt exposure, Bryan argued that the more recently launched Deutsche X-trackers USD High Yield Corporate Bond ETF (NYSEArca: HYLB) is a promising alternative. HYLB tracks an index similar to HYG’s but the Deutsche offering charges a much cheaper 0.25% expense ratio. The only drawback is that it was launched in December 216 and has not established a strong track record.
For more information on speculative-grade debt securities, visit our junk bonds category.