• / Free eNewsletters & Magazine
  • / My Account
Home>Research & Insights>Investment Insights>Are High-Yield ETFs Junk?

Related Content

  1. Videos
  2. Articles
  1. Caution Signs for CEF Income

    As fixed-income CEFs appreciate, investors seeking yield should be cognizant of bond rollover into lower-yielding assets as well as the added risk of leverage, says RiverNorth's Patrick Galley.

  2. Active, Passive, or Both?

    A successful portfolio might include components of both indexing and active fund management, says Morningstar's Christine Benz.

  3. 3 Reasons Your Asset Allocation May Not Be What It Appears

    Tax effects, maneuvers by your active fund managers, and the global sales of multinational companies can impact your actual portfolio exposures.

  4. Where Active Has Beaten Passive This Year

    After a rough 2011 for active managers, the average active fund has beaten its benchmark in only two categories in 2012. Is the trend here to stay?

Are High-Yield ETFs Junk?

The high-yield bond market poses unique challenges to index funds that make an active approach more attractive.

Alex Bryan, 04/26/2017

The high-yield bond market is not very conducive to index investing. High-yield bonds are expensive to trade and more likely to be mispriced than more heavily traded securities in less-fragmented markets.

The high-yield bond indexes underlying the largest exchange-traded funds attempt to work around the liquidity challenges of this market by sticking to the largest and most heavily traded bonds and weighting them by market capitalization. This approach pulls them toward the most heavily indebted issuers, which can increase the risk and make them less representa­tive of their active peers than stock index funds. Additionally, the typical high-yield bond index fund doesn’t enjoy as large of a cost advantage over its actively managed peers as counterparts in many other catego­ries. All these factors diminish the appeal of indexing high-yield bonds.

With this in mind, it’s not surprising that the two largest index funds in the high-yield Morningstar Category, SPDR Bloomberg Barclays High Yield Bond ETF JNK and iShares iBoxx $ High Yield Corporate Bond HYG, haven’t distinguished themselves from their actively managed peers. Both funds carry Morningstar Analyst Ratings of Neutral. In Morning­star’s view, high-yield bond investors would probably be better off with Vanguard High-Yield Corporate VWEHX, as a closer look will reveal. Although this is an actively managed strategy, it possesses some of the most important traits of a good index fund: low turnover and very low fees. The fund’s fee is a fraction of what its largest ETF peers charge, and it carries a Silver rating.

Trading Challenges
Investing in illiquid markets, like high-yield bonds, is a challenge because thinly traded securities are difficult to obtain and expensive to trade. Index fund managers can face particularly high transaction costs when they mechanically trade to match index changes. This is because they often prioritize timeliness of execution over cost. When the supply of a bond in a fund’s benchmark index is limited (as is often the case), those bonds’ prices must move to satisfy demand from index fund managers. These costs tend to increase with turnover.

The indexes that JNK and HYG track screen their hold­ings for liquidity to reduce transaction costs and make it easier for index managers to obtain the requi­site bonds. For example, to qualify for inclusion in the Bloomberg Barclays High Yield Very Liquid Index, which JNK follows, bonds must have at least $500 million in par value outstanding, be among an issuer’s three largest bonds, and have been issued less than five years ago. Similarly, HYG’s benchmark, the Markit iBoxx USD Liquid High Yield Index, requires holdings to have at least $400 million in par value, and the issuer must have at least $1 billion in total debt outstanding.

JNK Versus HYG
Deciding between these two ETFs can be a difficult task because they have a lot in common. They both focus on the most-liquid segment of the high-yield bond market and weight their holdings by market cap, resulting in similar portfolios. All else equal, expenses would likely be the deciding factor in choosing between the two. This would tip the scale in favor of JNK, which charges a 0.40% expense ratio, slightly lower than HYG’s 0.50% fee. But JNK has exhibited greater tracking error and turnover and has generated a slightly lower return from December 2007 (the first full-month data that are available for both funds) through December 2016 with greater risk, as shown in Exhibit 1. On top of that, it currently has greater exposure to bonds rated CCC and below, as Exhibit 2 illustrates.

Off Track?
Why does it seem like JNK is missing its mark? Part of the performance gap (2.27 percentage points annual­ized) between JNK and its index owes to a difference between how its index is calculated and how the fund transacts in the market. The index’s performance is calculated using the bid prices of the underlying bonds. These bid prices are lower than the ask prices the fund typically pays when it purchases new bonds.


Alex Bryan is an ETF analyst with Morningstar.

©2017 Morningstar Advisor. All right reserved.