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This Fixed-Income ETF Has Its Trade-Offs

This high-yield bond index fund attempts to avoid some of the pitfalls of market-cap weighting, but it may introduce a new problem.

Alex Bryan, 06/27/2014

Traditional market-capitalization-weighted bond indexes get a lot of flak for assigning the largest weights to the most-heavily-indebted issuers. For instance, it may not be optimal for investors to hold more General Motors GM debt just because GM needs to raise more money. Market-cap-weighted equity indexes share this potential drawback. Companies that issue stock can increase their market capitalizations without any changes in the fundamentals of the business, simply by raising more cash through the sale of additional shares to the public. However, this issue is likely less pronounced for stock than bond indexes because most companies rely more heavily on debt financing. Skewing toward the most-indebted issuers may be particularly problematic in the high-yield bond market because these issuers may carry greater default risk than their less indebted counterparts. The biggest debtors may also be more likely to suffer a credit-rating downgrade, which could hurt performance.

PowerShares Fundamental High Yield Corporate Bond PHB attempts to address this issue by weighting its holdings according to fundamental measures of their issuers' size, including sales, cash flow, dividends, and the book value of their assets. This approach may give the fund less exposure to heavily indebted companies than its peers that weight their holdings by the market value of each issue. But where market-cap weighting offers the advantage of tilting a portfolio toward the most-liquid bonds, this fund may overweight some of the less liquid issues. These bonds can be more difficult to obtain and more expensive to trade. In order to limit this potential problem, the fund's benchmark, the RAFI Bonds US High Yield 1-10 Index, restricts its holdings to issues with at least $350 million in par value outstanding.

Yet this benchmark may still be more difficult to replicate than a market-cap-weighted index. Over the trailing three years through March 2014, PHB lagged its benchmark by 1.26% annualized, considerably more than its 0.50% expense ratio. This underperformance does not inspire confidence, and if it continues, it could erode the index's potential performance edge relative to a market-cap-weighted alternative.

Although the fund's fundamental weighting approach may reduce its exposure to the most-indebted companies, nearly all high-yield bonds are issued by companies with a high degree of leverage. Companies can get there either intentionally by way of a debt-financed acquisition or recapitalization, or unintentionally as a result deteriorating business fundamentals. Either way, the risk posed by leverage is the same. As leverage increases, so does the probability of default and bankruptcy. The high yield that these bonds offer is compensation for this risk.

In contrast to some of its index peers, PHB excludes bonds that either Moody's or S&P rate below B3/B-. This exclusion may help improve the fund's risk-adjusted performance. Investors reaching for yield may be tempted to tilt toward the lowest-grade bonds and, in their quest for income, push the prices of these bonds above their fair values. During the past 10 years, the Bank of America Merrill Lynch US High Yield CCC or Below Index generated lower risk-adjusted returns than the corresponding BB and B indexes. The CCC index's option-adjusted spread (yield adjusted for embedded options, minus the yield on duration-matched Treasuries) is currently the lowest it has been since 2007. This means that the incremental reward for bearing this credit risk is lower now than it has been during the past few years.

During the past 10 years, BB rated bonds offered better risk-adjusted returns than their investment-grade and lower-credit-quality counterparts. Most investment-grade funds cannot hold BB rated securities, which can create forced selling when investment-grade issues are downgraded to BB. These issues may also be less attractive to investors reaching for yield than their lower-quality counterparts. As a result, they may become undervalued relative to other bonds. BB/Ba bonds account for close to 60% of PHB's assets, which may give it a more favorable risk/reward profile than many of its peers, even if it offers a slightly lower yield.

As of this writing, PHB carries a 4.4% yield to maturity. While this yield may appear attractive relative to investment-grade alternatives, high-yield bonds' spread over Treasuries is currently fairly low. As of June 20, 2014, the option-adjusted spread on the Bank of America Merrill Lynch US High Yield Master II Index (a commonly cited high-yield bond benchmark) was about 3.4%. Since the end of 1996 (the earliest this data is available), the median spread was 5.3%. Credit spreads tend to widen during recessions and times of uncertainty, when issuers may have less capacity to service their debt. For instance, the spread on the high-yield index grew to more than 20% at the end of 2008 and jumped again toward the end of 2011 during the European sovereign debt crisis. However, credit spreads have been tightening during the past couple of years as economic conditions have improved.

This sensitivity to the business cycle causes high-yield bonds to behave more like equities than investment-grade bonds. The Bank of America Merrill Lynch US High Yield Master II Index was 0.74 correlated with the S&P 500 during the past decade. During that time, it was only 0.27 correlated with the Barclays U.S. Aggregate Bond Index.     

Alex Bryan is an ETF analyst with Morningstar.

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