The strong outperformance of credit-related securities and progressive trend in interest rates has emboldened many investors to bulk up on high yield funds over the course of this bull market. The minimal dividends from traditional CDs and high-quality Treasury bonds leaves little to be desired when compared to corporate or municipal debt yielding magnitudes of greater income.
Popular funds in this category include the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and SPDR High Yield Corporate Bond ETF (JNK). Together these two ETFs control over $33 billion in total assets and continue to expand with each passing year. The combination of high dividends, consistent capital appreciation, and relatively low volatility have made for an attractive opportunity for many income investors portfolios.
Because of this swelling trade, I am often asked whether or not a high yield ETF is considered a “safe investment” to own. The answer of course is more nuanced than some would expect.
Every fund will have its own unique risk profile that must be evaluated in conjunction with the individual investors’ personal expectations. Furthermore, there are key distinctions between owning an index fund with relatively static holdings versus an actively managed basket with the flexibility to shift their strategy at will.
In either situation, the core of this analysis is based on three important criteria:
- Credit quality of the underlying holdings.
- Effective duration of the fund.
- Risk tolerance of the investor.
Credit quality is an important statistic because it measures the strength of the underlying issuer’s ability to repay their debt. Lower credit quality securities are going to offer higher yields and a greater associated risk of principal invested. Conversely, higher credit quality securities will result in lower yields and less relative volatility.
ETF issuers do a solid job of depicting the underlying portfolio exposure to various credit rating tranches on their websites. This allows investors the ability to examine or compare similar funds to determine if there is an overly ambitious allocation to securities at higher risk of default.
Another aspect of a high yield bond portfolio to note is the effective duration of the underlying holdings. Bonds with a longer maturity date are more likely to be impacted by the fluctuations in interest rates than similar securities with much shorter maturity dates.
Many investors opt to mitigate this risk by owning funds that focus on shorter duration securities such as the PIMCO 0-5 Year High Yield Corporate Bond ETF (HYS). This index fund has an effective duration of 1.85 years compared to the 3.5-year duration of HYG. All things being equal, HYS would carry less sensitivity to interest rates than its intermediate-term rivals.
Lastly, it’s essential to consider the unique risk tolerance of each investor who is willing to own these holdings. Many have become so comfortable in the last two years of historically low volatility and almost non-existent default rates that they are psychologically unprepared for any decline of 5% or more. High yield bond funds could easily undergo a bear market similar to stocks during a prolonged period of rising interest rates, severely tightening credit conditions, or both.
Many investors who have become overly dependent on high yield bonds may ultimately find themselves wishing for a more diversified exposure profile when the market hits a speed bump.
The Bottom Line
There is no free lunch in the income-producing world. Every incremental bump in yield is going to come with an equal dose of higher risk for the investors who are participating. Credit sensitive securities perform best during periods of abundant liquidity and global stock market expansion such as what we have experienced over the last several years. They ultimately will face greater headwinds on the downside of that cycle as risk behavior turns and greater emphasis is placed on safety.