The concept of smart beta in the fixed income arena is still relatively new, but it rapidly spread, moving beyond aggregate bond funds to investment-grade and even high-yield corporates. An example of smart beta junk bond fund is the IQ S&P High Yield Low Volatility Bond ETF (NYSEARCA: HYLV).

HYLV tracks the S&P U.S. High Yield Low Volatility Corporate Bond Index. That index “is designed to measure the performance of U.S. high yield corporate bonds with potentially low volatility. The index is comprised of bonds from the S&P U.S. High Yield Corporate Bond Index and is a modified market value-weighted index with a 3% cap on any single issuer,” according to S&P Dow Jones.

HYLV’s approach is relatively straight forward, giving it something of an advantage over more complex smart beta fixed income offerings.

“Analyzing smart beta ETFs in fixed income is more complicated than in equities as bonds are more complex instruments than stocks and factor definitions are less homogeneous,” said Nicolas Rabner of Factor Research in a recent note. “Value results in a higher yield while Quality and Low Volatility portfolios are comprised of less risky bonds and therefore feature lower yields.”

A Good Time for HYLV

With a massive number of corporate downgrades hitting the market, HYLV could be worth a look over the near-term.

Volatility rankings have acted as an early indicator of rating changes. After reviewing rating changes from B to BB and vice versa over a period from the 4th quarter of 1996 through the 2nd quarter of 2019, it was shown that a bond’s volatility ranking generally started to improve 25–30 months before the rating upgrade happened. Low-volatility bonds have also historically exhibited less credit risk than high volatility bonds.

“The US high yield bond market offers investors more factors than other fixed income market segments, but it is still only three strategies,” said Rabner. “One of the Quality ETFs was launched in 2007 and therefore offers a long track record for analysis. Likely unexpected by investors, the Quality strategy led to a larger maximum drawdown during the global financial crisis in 2008 to 2009 and a significantly lower return than the benchmark over the last 12 years. The Low Volatility and Value ETFs were launched in the last couple of years and performance has been similar to that of the benchmark.”

Proving that HYLV can benefit high-yield investors, the fund is outperforming the largest junk bond ETF by nearly 500 basis points year-to-date.

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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.