High-Yield Bonds: Are ETFs the Best Vehicle?

High-yield exchange-traded funds (ETFs) have been growing like gangbusters in recent months, despite continued weak performance relative to the indices that they track. While these instruments make sense for investors who make rapid, tactical trades into and out of the asset class, we think they’re a poor choice for those seeking to gain long-term exposure to high-yield bonds. Below, my colleagues Ashish Shah and Gershon Distenfeld explain why.

Torrential flows

Early in 2012, the steady flow of funds into the high-yield ETF market became a torrent. Although ETFs still represent just 2% of the high-yield market, about one-third of the flows into the high-yield bond market this year have gone into ETFs. What’s the appeal?

First of all, high-yield bonds themselves are attractive. With interest rates at historic lows around the developed world, there are few remaining bond sectors that still offer attractive yields. And as we’ve written before, high-yield bonds have historically offered comparable returns to equities, with about half the volatility. That’s an attractive proposition for investors looking to reduce their portfolio risk.

Second, high-yield ETFs appear to offer a convenient vehicle for exploiting this opportunity. ETFs in and of themselves are relatively liquid. Unlike mutual funds, which are priced just once a day, ETFs are traded on exchanges and thus can be bought or sold at any time, just like stocks. Also, management fees for ETFs are lower than for actively managed mutual funds—and even for passively managed mutual funds.

Since the existing high-yield ETFs are index funds, investors see them as an easy and efficient way to gain exposure to the asset class, much as they might use an ETF to represent the S&P 500 Index or US Treasuries. Thus, many investment advisors use ETFs as core holdings in their clients’ portfolios. The problem is, high-yield ETFs haven’t done a very good job of tracking benchmark indices.

Poor performance

In fact, high-yield ETFs have significantly underperformed since 2007, when the market for them first took off. An asset-weighted composite of the two largest high-yield funds, JNK and HYG—which together now comprise roughly 90% of all assets in the high-yield ETF marketplace—has delivered an annualized return of 6.4% since the end of 2007. That’s well short of the 10.0% annualized return for the Barclays Capital US High Yield Very Liquid Index. The performance gap has steadily widened over the last three years, as the high-yield market has enjoyed its biggest rally on record, as the Display below shows.

High-Yield ETFs May  Be Passive, but They Have Lagged the Index for Years

What’s the source of this underperformance? A high-yield ETF isn’t like an ETF tracking the S&P 500 or US Treasuries. Bonds go into and out of the high-yield benchmarks far more often than stocks go into and out of the S&P 500, so ETF managers are forced to trade more in the high-yield bonds that make up the index.

And unlike most large-cap stocks or US Treasuries, many high-yield bonds are very illiquid. Specific bonds often trade infrequently, and transaction costs can be high. Bid/ask spreads typically range from 0.75% to 1% in the high-yield market, but sometimes go as high as 2%. That’s far higher than a typical bid/ask spread of less than 0.01% for Treasuries and 0.03% to 0.04% for the components of the S&P 500.

Of course, high turnover and transaction costs can be an issue for high-yield mutual funds, too—and high-yield mutual funds, on average, have also underperformed the index, but by less. Hefty flows into and out of ETFs (they have represented over 50% of the trading in high-yield cash bonds year to date) mean that such costs can mount more quickly for ETFs, eroding returns to investors in these instruments.

Furthermore, there is significant dispersion in the results for actively managed high-yield mutual funds that data on average performance masks. Investors have the opportunity to gain higher performance by picking a skilled active manager. They don’t have the same opportunity with high-yield ETFs, because there’s less dispersion in the results.

In addition, popular high-yield ETFs tend to trade at a premium to their net asset value (NAV), due to large inflows based on strong appetite for yield among retail investors. In theory, this shouldn’t last long. When a closed-end fund trades above NAV, market makers usually sell shares in the fund and buy the cheaper underlying securities. The same arbitrage process occurs with ETFs, and usually helps keep ETF market prices in line with their underlying value.

But in illiquid markets such as high yield, the arbitrage process tends to break down. It’s simply too hard for traders to gain access to the underlying securities. The end result is that high-yield ETF investors overpay for the underlying investments.

To be sure, ETFs are useful instruments for short-term trading. But in illiquid markets such as high yield, we think they’re a poor solution for investors seeking longer-term exposure to an asset class. In such cases, we think the odds are greater that a skillful active manager will outperform over a full market cycle. In our view, investors would be better off selecting a well-managed mutual fund.

For more on this topic, see "Beware Costs, Underperformance in High Yield ETFs," which  Michael Aneiro wrote for Barron's after interviewing Gershon Distenfeld. 

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The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio- management teams.

Douglas J. Peebles

Chief Investment Officer—AllianceBernstein Fixed Income
Douglas J. Peebles joined the firm in 1987 and is the Chief Investment Officer and Head of AllianceBernstein Fixed Income. In this role, he supervises all of the Fixed Income portfolio management and research teams globally. In addition, Peebles is Chairman of the Interest Rates and Currencies Research Review team, which is responsible for setting interest-rate and currency policy for all fixed-income portfolios. He has held several leadership positions within Fixed Income, including director of Global Fixed Income from 1997 to 2004 and co-head of AllianceBernstein Fixed Income from 2004 until 2008. He holds a BA from Muhlenberg College and an MBA from Rutgers University. Location: New York

Ashish Shah

Head—Global Credit
Ashish Shah is Head of Global Credit and a Partner at AllianceBernstein. He is also a member of the Absolute Return portfolio-management team. Prior to joining the firm in 2010, Shah was a managing director and head of Global Credit Strategy at Barclays Capital, where he was responsible for the High Grade, High Yield, Structured Credit and Municipal Strategy Groups, and the Special Situations Research team. Prior to that, he served as the head of Credit Strategy at Lehman Brothers, leading the Structured Credit/CDO and Credit Strategy Groups and covering the cash bond, credit derivatives and CDO product areas for global credit investors. Before that, Shah served as North American CFO at Level 3 Communications from 1999 to 2000 and gained trading experience at Soros submanager Blue Border Partners and at Bankers Trust, where he ran US equity arbitrage from 1994 to 1999. He holds a BS in economics from the Wharton School at the University of Pennsylvania. Shah has long been committed to diversity issues and has led several key diversity-related initiatives across the firm. Location: New York

Gershon M. Distenfeld, CFA

Director—High Yield
Gershon M. Distenfeld is Senior Vice President and Director of High Yield, responsible for all of AllianceBernstein’s US High Yield, European High Yield, Low Volatility High Yield, Flexible Credit and Leveraged Loans strategies. He also serves on the Global Credit, Canadian and Absolute Return fixed-income portfolio-management teams, and is a senior member of the Credit Research Review Committee. Additionally, Distenfeld co-manages the High Income Fund and two of the firm’s Luxembourg-domiciled funds designed for non-US investors, the Global High Yield and American Income Portfolios. He has authored a number of published papers and initiated many blog posts, including “High Yield Won’t Bubble Over,” one of the firm’s most-read blogs. Distenfeld joined the firm in 1998 as a fixed-income business analyst. He served as a high-yield trader from 1999 to 2002 and as a high-yield portfolio manager from 2002 until 2006, when he was named to his current role. Distenfeld began his career as an operations analyst supporting Emerging Markets Debt at Lehman Brothers. He holds a BS in finance from the Sy Syms School of Business at Yeshiva University and is a CFA charterholder. Location: New York

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