Look Beyond ETFs for Long-Term High-Yield Exposure

Paul Justice: Investors have withdrawn $83 billion from mutual fund and ETF equity securities over the last year.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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Strauts: Well, one of the things people look at is when they look at high-yield bonds is they oftentimes look at some of the historical returns they have produced, looking at the major indexes. If you go back to that Merrill Lynch Index, it's produced over 2% excess returns over comparable investment-grade bonds, which is attractive--2% excess returns are very attractive.

Unfortunately, my colleague Sam Lee wrote an article looking at some of the data, and he showed that if you actually look at investible products--mind you, indexes are not investible--if you look at the investible universe, you don't get anywhere near those returns, mainly because the best, most attractive bonds are the least liquid smallest issues in the index.

So, basically, they're very hard to buy. And especially an ETF, which has to maintain liquidity and is traded throughout the day, has very little ability to own any of these very illiquid securities in the high-yield space. So, because it doesn't own the illiquid portions, it has lower returns historically.

Justice: So, really for an ETF to function well, you need liquid underlying markets; we're not seeing as much liquidity there as we would see in, say, the large-cap equity space. So, clearly, that's going to result in some things like a performance drag, a wide bid/ask spread, some tracking error to the underlying index--which certainly isn't, I'd guess, only going to impact ETFs; it could affect mutual funds as well?

Strauts: The mutual funds have the same problems. It's just that [with] the daily trade in the ETF, you see it more prevalent on a daily basis. You will see the high-yield ETFs will trade at premiums and discounts, sometimes substantial [ones] in the range of 3%-4% in a volatile market. And that's just because they offer daily liquidity, but the market maker, who is making these markets, has to give themselves a cushion because they are having difficulty pricing their securities. So, they sell for higher or lower than the net asset value is indicating.

Justice: Now, I am a strong proponent of indexed-based products. In the high-yield space, though, that might not be the best way to go. There's been some research that showed that some of the most illiquid offerings are often the highest-returning over time.

Strauts: Yes, that's definitely the case. It's very difficult for the ETF, the funds, to actually take advantage of that. So, in general, it doesn't mean high-yield ETFs don't ever make sense, but as a long-term asset allocation plan, it may make sense to look into some other options.

Justice: Now, just in case investors are still looking into this space, there have been some product launches--naturally, when we see asset flows, product providers come forward and bring these things to the marketplace. What are a few of the new issues, and what should investors really think about these?

Strauts: Well, one thing we're really seeing is that they've already launched all the main high-yield indices. So they are not going to launch another U.S. high yield. So they have been going globally now. So, now there has been a global high-yield, international high-yield, and specifically emerging-markets high yield, which just seems they're going stretching further and further away from an investor's core competency.

I am a fixed-income analyst, but I couldn't even say exactly the credit qualities of some of these emerging-market high-yield corporate bonds that are in some of these indexes.

So the two funds are Market Vectors Emerging Markets High Yield Bond, ticker is HYEM, and then the iShares Emerging Markets High Yield Bond EMHY. Both very new funds; I actually expect them to probably get some decent flows in the next few months.

Justice: Probably from investors who are really looking and saying, I believe the emerging-market story is going to work out, that these countries really are going to evolve into the developed-world status, and maybe I'm going to get a benefit of that growing economy. But do you think the risk profile of that return is going to play out well for investors.

Strauts: In short-term looking at it, we have a very uncertain global economic situation, and these bonds are not cheap. If you just look at credit spreads in that space, still not cheap; you're probably setting yourself up for failure here.

Justice: Well, good words of caution. Thank you, Tim, for giving us those insights.

Thank you for joining us. For this and more ETF investing news, please check out our ETF Investing Center at Morningstar.com or our ETFInvestor news site.