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ETF Specialist

Only the Highest Quality Junk (Bonds)

This ETF follows a rules-based index that avoids the lowest-rated junk bonds.

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Unlike traditional bond indexes, which typically give higher weightings to issuers with the greatest amount of debt,  PowerShares Fundamental High Yield Corporate Bond Index's (PHB) index-weights its holdings according to fundamental measures of issuers' size, including sales, cash flow, dividends, and the book value of their assets.

This, along with the rules-based benchmark's exclusion of any bonds rated CCC or lower, results in a portfolio of junk bonds with a relatively smaller allocation to the riskiest issuers compared with its market-cap-weighted peers. Cap-weighted exchange-traded funds  iShares iBoxx $ High Yield Corporate Bond (HYG) and  SPDR Barclays High Yield Bond (JNK) have 10% and 14% of their portfolio in bonds rated CCC or lower, respectively. As such, this fund may fit the bill for investors looking for a less aggressive high-yield option. However, a potential drawback of the fund's higher-turnover strategy, which tilts away from the largest issuers, is that higher transaction costs may lead to greater tracking error, as has been the case historically.

High-yield bonds could hold up relatively well in the event of rising interest rates and inflation, thanks to the asset class' stocklike returns and heavier dependence on business fundamentals. During the past 10 years, U.S. high-yield bonds have shown a positive correlation (74%) with the S&P 500, while the Barclays U.S. Aggregate Bond Index has been relatively uncorrelated (25%). Interest rates typically will rise when the economy is in good shape and businesses are performing well. High-yield bonds tend to perform well when issuers' fundamentals are strong or improving but can be vulnerable to economic slowdowns and flights to quality.

Tactical investors may look to a fund like PHB as a way to bolster income in a yield-starved environment. However, the current yield is compensation for credit risk and should be viewed in relation to the yield offered by U.S. Treasuries with the same maturity. The difference between the two is known as the credit spread, and it represents the premium investors can collect for assuming the additional credit risk. Remember that since PHB excludes issuers rated below B, it will have a slightly lower risk premium than its peers that cover the entire high-yield market.

Fundamental View
The income potential of high-yield bonds amid a low-interest-rate environment has garnered interest among yield-starved investors. This increased investor demand has led to lower yields as prices moved higher. Still, there are very few other investments that currently offer mid-single-digit yields. Other factors to consider include the asset class' ability to withstand the impact of rising interest rates, potential inflation, and an uptick in the default rate (credit risk).

The asset class' generally accepted benchmark, the Bank of America Merrill Lynch High Yield Master II Index, generated annualized total returns of 6.0% and 7.5%, respectively, over the trailing five- and 10-year periods through October 2015. The S&P 500 returned 14.3% and 7.9%, respectively, during the same periods but did so with greater volatility. The annual standard deviation of high-yield bonds during the past 10 years through October 2015 clocked in at 10.5% compared with 14.9% for the S&P 500.

High-yield bonds could be positioned to outperform high-quality U.S. government issues if interest rates rise, as rising rates typically coincide with a strengthening economy, which is a positive for economically sensitive borrowers. As a result, credit spreads could tighten further and help offset the negative effect of rising rates.

Of course, these advantages don't come without significant risk. For starters, the high-yield bond asset class has never weathered a sustained period of rising rates. Broad-market bond yields have trended lower during the past 30 years, so there is no true litmus test on how the asset class will react if and when they increase. It does, however, underperform during periods of economic weakness and flights to quality. For example, in 2008, the BofAML HY Master II Index fell by almost 30% as markets were roiled by the global credit crisis. In contrast, the U.S. investment-grade bond market, as represented by the Barclays U.S. Aggregate Bond Index, gained nearly 5% in 2008.

Unlike high-quality credits and government bonds, junk bonds do not serve as portfolio ballast when markets are in turmoil. Investors are getting paid a bit less than they have historically to take on the credit risk associated with junk bonds. The option-adjusted credit spread between the BofAML HY Master II Index and U.S. Treasuries dipped as low as 335 basis points in the summer of 2014 but has since widened to about 600 basis points. Spreads inched back above the historical median and average of 514 basis points and 579 basis points, respectively, since the end of 1996 (the earliest these data are available).

Accommodative funding conditions and a recovering economy have kept a lid on high-yield bond default rates, but that may not be the case in the future. According to Moody's, the default rate for high-yield issuers over the trailing 12 months through July 2015 was 2.4%. That marked five consecutive years that the default rate was below its long-term historical average of 4.5%, since 1983. Many of the highest-risk issuers have taken advantage of favorable credit markets in recent years to extend their maturity profiles. However, distressed issuers in the energy and materials sectors are likely to drive the default rate higher in the intermediate term.

Portfolio Construction
The fund employs representative sampling to track the RAFI Bonds U.S. High Yield 1-10 Index, which starts with the universe of nonconvertible, fixed-coupon, high-yield corporate bonds with up to 10 years until maturity. All issuers must be publicly traded companies. Each bond in the index must also have a par value of at least $350 million outstanding and carry either a Moody's or S&P rating of BB+/Ba1 or lower but not below B3/B-. That means that the fund may hold some bonds rated BBB/Baa by one credit rating agency, as long as the other credit rating agency assigned a BB+/Ba1 rating or lower (but above B3/B-). The index is not capitalization-weighted but instead uses four fundamental factors to weight issuers. To construct the index, each issuer is assigned a weighting based on the percentage of its sales, cash flow, dividends (where applicable), and book value of assets relative to the aggregate values of each of those metrics. To reduce turnover, the index uses five-year averages for each factor, except book value. The index averages those four values to assign each issuer's weighting. For companies that do not pay dividends, the average of the other three factors determines the issuer's fundamental weighting. If the issuer has more than one qualifying bond, the index selects the largest issue with one to five years to maturity and the largest issue with five to 10 years to maturity. Therefore, there can be up to two bonds per issuer. In these cases, each bond is equally weighted. The fund and the index are reconstituted annually in March and are rebalanced monthly.

This fund charges an expense ratio of 0.50% per annum, which is on par with its high-yield ETF peers and much cheaper than actively managed high-yield bond funds. Tracking performance, however, may add to its cost. Over the trailing three- and five-year periods through October 2015, the fund lagged its benchmark by 0.84% and 1.15% annualized, respectively. PHB's exaggerated tracking error is mostly attributable to transaction costs associated with its higher-turnover strategy.

Fixed-income indexes typically price constituent securities at the bid price. However, PHB's index prices bonds that are entering the portfolio, as well as existing holdings being rebalanced, at the midprice. Bonds exiting PHB's index are priced at the bid. By pricing incoming and rebalancing bonds at the midpoint of the bid-ask spread, the index is, in effect, including transaction costs in its index calculation. Therefore, it's worth noting that if the benchmark consistently priced bonds at their bid price, as per the industry standard, then PHB's tracking performance would look even lousier.

The two largest and most heavily traded high-yield bond ETFs are iShares iBoxx $ High Yield Corporate Bond and SPDR Barclays High Yield Bond. In contrast to PHB, these funds are based on market-cap-weighted indexes. SPDR's JNK is slightly cheaper with an expense ratio of 0.40%, while iShares' HYG charges the same fee of 0.50% per year.

HYG, which has more than 1,000 holdings, uses representative sampling to track the Markit iBoxx USD Liquid High Yield Index. At 4.18 years, HYG's effective duration is right on par with PHB's (4.34 years). However, it takes on more credit risk and, as a result, has a higher average yield to maturity of 7.2% (versus 5.9% for PHB).

JNK also employs a representative sampling strategy to track its benchmark, the Barclays Capital High Yield Very Liquid Index. At 4.36 years, JNK's modified duration is in line with PHB's, but its lower-quality portfolio has a higher average yield to maturity of 8%. PHB doesn't hold any issues rated below B, while HYG and JNK hold 10% and 14% stakes, respectively, in bonds rated CCC or lower.

Investors concerned about the impact of rising interest rates may also consider PIMCO 0-5 Year High Yield Corporate Bond (HYS), which charges an expense ratio of 0.55%. This fund's effective duration of less than two years is considerably lower than the other alternatives. Still, HYS offers an attractive estimated yield to maturity of 7.6%. Actively managed  Fidelity High Income (SPHIX) (0.72% expense ratio) may be more appealing for investors looking for an actively managed high-yield alternative. As of November 2015, it was the only high-yield U.S. open-end mutual fund that carried a Morningstar Analyst Rating of Gold.

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John Gabriel does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.