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When Indexing Fails: Junk Bonds

Just because junk-bond ETFs trade well does not mean they track their asset class well.

Samuel Lee, 07/18/2012

The popularity of indexing has become indiscriminate. Some asset classes are not amenable to indexing, and some exchange-traded funds should be avoided for that--especially junk-bond ETFs. These products fail on two levels: Their underlying asset class may be systematically overpriced, failing to offer returns commensurate with their risks, and their price-indifferent trading imposes enormous hidden costs on investors.

Illusory Returns, Real Risk
At first glance, the historical record contradicts me. Over the past 26 years, junk bonds, proxied by the BoAML U.S. High Yield Master II Index, have returned 8.8% annualized with an 8.6% standard deviation, for a 0.58 Sharpe ratio. Most investors would envy such a record. However, much of the return came from decades of declining interest rates, which provided a big capital appreciation boost. Junk bonds look less impressive against duration-matched Treasuries, outperforming by 200 basis points and with much higher volatility. Not bad, but much of the return advantage is illusory. To get a sense of how difficult it was to obtain the index's returns, look at junk-bond mutual funds. Of the 27 high-yield funds that have survived since 1986, the starting year of the high-yield index, not one earned a higher Sharpe ratio than the index, and only one posted higher absolute returns. These are the winners; the ones that died off posted much worse returns.

  - source: Morningstar Analysts

Mutual funds had a hard time matching index returns owing to the illiquidity of the market. Many junk bonds trade irregularly, so index prices are often estimated using "matrix pricing" models, which produce interpolated prices based on a handful of reference bonds. These prices are often impossible for investors to obtain. If so few funds can get close to the index's returns, then the index's returns are fiction. We get closer to reality with liquidity-screened indexes, such as the iBoxx Liquid High Yield Index.

Since its 1999 inception, iBoxx's index has trailed the broad junk-bond index by 1.72%, eliminating most of the asset class' excess returns. This finding is consistent with previous studies showing that much of the excess returns from less-liquid asset classes come from the least-liquid tranches. According to the Ibbotson SBBI 2012 Yearbook, over the period 1972 to 2011, the least-liquid quartile of small-cap U.S. stocks drove much of small caps' outperformance; the most-liquid small caps actually lagged the most liquid large caps by 6.5% annualized.

With much of the illiquidity premium excised from investable junk-bond indexes, you're left with an awful asset class that has provided scant return above Treasuries, more volatility, and, worst of all, inferior diversification. Junk-bond ETFs during the financial crisis experienced 30%-plus losses, whereas duration-matched Treasuries shot up in the flight to quality.

Structurally Overpriced?
The poor compensation for liquidity risk junk-bond investors have received suggests the market has historically been overpriced. Of course, poor realized returns don't condemn an asset class or strategy, even over a period of as long as three decades. But they are very suggestive when the data are considered in context.

1) Credit risk has been poorly compensated. From 1926 to 2012, long-term corporates have returned less than 0.40% annualized over long-term government bonds, with most of the excess returns occurring during the 1930s. Over the past 50 years, credit risk in long corporate bonds has provided close to zero excess return over Treasuries.

2) Distress risk has been poorly compensated. The most distressed stocks have had terrible returns, and CCC-rated bonds, among the most distressed bonds, have actually lost money versus Treasuries.

The persistence of such poor returns to credit and distress risk over many decades suggests that systematic forces are elevating prices. The best two candidates are yield illusion and lottery seeking.

Investors may systematically overestimate expected returns to high-yield bonds by relying on traditional (and flawed) measures of yield spread. Options allow issuers to call their bonds at opportune times, and defaults whittle away at much of the yield advantage. Options-adjusted yield spreads do a better job providing junk bonds' prospective return advantage, but are sensitive to the assumptions used to generate them and, strangely enough, ignored by many investors.

In addition, the junkiest bonds exhibit lotterylike payoffs--a good chance of losing money, and a small chance of making many multiples on your investment--attracting a sizable class of investors willing to overpay for the dream of hitting it big.

In liquid, transparent markets, arbitrageurs act as countervailing forces. However, given the difficulty of short-selling illiquid securities, and the high cost of acquiring information, big deviations from fair value look set to persist in the junk-bond market.

ETFs Can't Transmute Lead to Gold
Junk-bond ETFs might seem like the philosopher's stone, wrapping an illiquid asset class with ample trading volume. But the liquidity is illusory; in the throes of the financial crisis, high-yield bonds stopped trading and the biggest junk-bond ETFs traded at huge discounts and premiums. Even the illusion of liquidity comes with a price. Index funds move prices against themselves by trading en masse--Antti Petajisto estimates that the Russell 2000 lost about 0.80% annualized to price impact. The problem is certainly much worse with illiquid junk bonds.

Tactical, Not Strategic
With sand in the mechanisms that keep junk-bond markets efficient, investors should not passively own junk bonds. Nor should they use them to make up for falling yields. Junk bonds should mostly substitute for equity allocations. Ideally, junk bond exposure should be delegated to active managers, giving them the ability to tactically allocate away from the market depending on spreads. Free-ranging bond funds like PIMCO Unconstrained Bond PFIUX are promising, but their expense ratios leave much to be desired.

This is not to say that the case for a strategic allocation to junk bonds is hopeless. With TIPS, commodities, and other inflation fighters trading at elevated levels, junk bonds are an attractive "stealth" inflation hedge, argues Rob Arnott. The rationale is sensible: Unexpected inflation reduces the real debt burden of distressed firms, reducing default risk, thereby shrinking credit spreads. However, junk bonds are still quite a new asset class--until the 1980s they were mostly "fallen angels," investment-grade bonds that fell into distress--and the U.S. has not gone through many significant bouts of inflation. The positive correlation between high-yield and inflation could be a statistical fluke of the 1970s.

With so many caveats to junk bonds, investors should use them with caution. Barring a strong tactical thesis, we'd pass on junk-bond ETFs for now.

A version of this article appeared in the May 2012 issue of Morningstar ETFInvestor.

Samuel Lee is an ETF Analyst with Morningstar.

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