Bond ETF investors should consider the potential benefits of high-yield debt and look to ways to incorporate these investments into their portfolios.
On the recent webcast (available On Demand for CE Credit), Potential Yield Maximization Strategies, Mark Carlson, Senior Investment Strategist at FlexShares Exchange Traded Funds, explained how high-yield debt has moved from a niche fixed-income option to a core portfolio holding.
The modern high yield sector began to gain prominence in early 1980s and the Bloomberg Barclays US Corporate High Yield Bond Index use to track a market value of just $43.9 billion back in 1990. The high yield market has survived the 80s, the Dot.com bubble, a credit bubble, the Great Recession and quantitative easing.
Now, with greater interest in diversifying holdings, the benchmark high-yield index now tracks a market worth $1.3 trillion as of the end of 2017. Over the past 20 years, the Bloomberg Barclays US Corporate High Yield Bond Index has generated a 6.55% annualized total return.
As the speculative-grade debt category matured over the years, Carlson pointed out that the greater acceptance of high yield for a source of capital has changed the investment characteristic of the junk bond market. For instance, the high-yield category now exhibits greater diversity, higher average ratings, lower credit premiums and a changed perception of perceived relative safety versus lower quality “junk” of old.
High-yield debt provides diversification by helping investors diversify fixed-income or rate risk and equity exposure. While high-yield is consider a riskier asset with higher correlation to equities than investment-grade debt, the debt category provides potential opportunities for positive risk-adjusted returns.
The high-yield segment may provide more diversification benefits than many realize. Carlson singled out the low correlation high-yields have exhibited against equities, investment-grade fixed income and interest rates. The Bloomberg Barclays High Yield Index has a 0.715 correlation to the S&P 500 Index – a 1 reading would reflect perfect correlation. The high yield index also has a 0.264 correlation to the Bloomberg Barclays U.S. Aggregate Index and a -0.227 correlation to the Bloomberg Barclays U.S. Treasury Index, reflecting its low correlation to traditional fixed-income asset exposures.
At FlexShares, Carlson argued that investors should focus on yield value. Similar to the equities market, fixed-income assets also exhibit factor characteristics. Examining the returns from style factors versus the Merrill Lynch High Yield US Corporate Bond Index from 2003 through 2016, the Value style has been the best performing factor, followed by quality and low volatility.
Furthermore, the coupon return is also seen as an important factor in high yield investing as the yield carry drives 111% of the return of the Bloomberg Barclays U.S. High Yield Index.
A Unique Screen for High-Yield Corporate Debt
To help capitalize on these factors in the high-yield segment, investors can look to the recently launched FlexShares High Yield Value-Scored Bond Index Fund (NYSE: HYGV), which utilizes a unique screen for high-yield corporate debt.
The FlexShares High Yield Value-Scored Bond Index Fund tries to reflect the performance of the Northern Trust High Yield Value-Scored US Corporate Bond Index, which hones in on value with a proprietary credit scoring model that maximizes factor inputs for value while at the same time, effectively screens for quality and liquidity risk. The bond issuers are then fundamentally evaluated against current market conditions, with low-quality issuers precluded from the index.
The ETF focuses on value by pursuing the higher risk/return potential found by concentrating on a targeted credit beta; utilizes Northern Trust Credit Scoring methodology to eliminate bottom 10% of issuers; performs liquidity assessment based on issuer’s debt outstanding, age and remaining time to maturity with the purpose of eliminating the bottom 5% illiquid securities; and intends to match the duration of a market cap weighted index (ICE BofAML US High Yield Index), while maintaining sector neutrality.
Financial advisors who are interested in learning more about yield-generating strategies can watch the webcast here on demand.