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By Paul Justice, CFA and Timothy Strauts | 05-16-2012 02:00 PM

Look Beyond ETFs for Long-Term High-Yield Exposure

ETFs have little ability to own the very illiquid securities that can be the most lucrative in the high-yield space, says ETF analyst Tim Strauts.

Paul Justice: Investors have withdrawn $83 billion from mutual fund and ETF equity securities over the last year. At the same time, over $225 billion have flowed into fixed-income products. This seems like a stark contrast to keeping an asset allocation intact. In fact, it goes well beyond rebalancing.

I'm Paul Justice, director of ETF research at Morningstar. Today we're going to talk about this rush to yield-seeking investments, especially within the ETF space, and joining me today is our fixed income analyst on ETFs Tim Strauts.

Tim, thanks for joining me.

Tim Strauts: Glad to be here.

Justice: Tim we've seen investors really clamoring for yield and possibly seeking some risk aversion, but not all the time. They are going into some pretty exotic products as far as the fixed-income landscape goes with ETFs. Could you talk about what categories are attracting a lot of interest within ETFs?

Strauts: It's kind of interesting. On a year-to-date basis, high-yield bonds are the second-largest category as far as inflows, with $7.5 billion going into high-yield bonds. Now, high-yield bond is kind of a niche category of the bond market, and it's the second-highest category.

The third category is intermediate-term bonds, and then below that there's a few other different bonds categories.

So, investors are clearly looking for the highest-yielding investments. They are upset that their savings account yield nothing, a regular intermediate-term bond fund is yielding 2% to 3%, and many of these people who have planned for retirement were hoping for 5% to 6% yields. And the only way to get that type of yield today is to stretch out into the lower credit quality area and go into high-yield bonds.

Justice: So, substituting equity risk for another potentially high-risk segment of the market.

Could you talk about the prospects of what high-yield bonds could give investors today? Is it really worth the risk? What type of return are we looking at?

Strauts: Well, yields are in 6% to 7% range. So, on the face of it, it looks pretty good, and if you look at current default rates, we are actually near all-time low default rates, because many of these firms have refinanced their debt over the last couple of years. So, defaults are low and yields are pretty good. So, on the surface, it looks pretty good.

But there is the other case. If you look at credit spreads, and one way to look at credit spreads is to use as the main index, the Merrill Lynch U.S. High Yield Master II Index, and currently the current credit spread on that index versus U.S. Treasuries is 6.15%. OK, so that's fine, but what is that historically? Well, the average is actually 6.0%. So, we are right at the historical average credit spreads, going all the way back to 1997.

Justice: Sure. This is no Goldilocks scenario, free money within high yield?

Strauts: No, and actually if you consider where we are with the U.S. economy being kind of weak and still struggling to recover, we have the European situation which every day or week looks like it's getting a little bit worse. Greece, maybe leaving the euro at some point in the next year or two, it doesn't seem like a situation where we should have average credit spreads. You would think they would be much higher than they are today, but the reason they are down where they are, is that there are massive inflows into high-yield bond funds and ETFs which have lowered credit spreads.

Justice: So, as [PIMCO's] Mohammed El-Erian would say, maybe the cleanest dirty shirt in the bunch?

Strauts: Yes.

Justice: So now let's talk about the ETF structure--maybe people are comfortable with taking that risk at this point in time. They are saying high-yield bonds are right for me. What are some of the concerns investors should have if they are looking for that exposure through an ETF?

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