Defensive Exposure to High-Yield Bonds

High-yielding, low-risk bonds are about as rare as loose $20 bills on the sidewalk. When such an opportunity arises, investors clamoring for the easy money should bid the price of the bond up until its yield is driven down to a level commensurate with its risk.

Because of this competitive pressure, bond yields are one of the best indicators of bond risk. The higher the yield, the riskier the bond. Reaching for yield can be dangerous, but many do it anyway. This can push the prices of the riskiest bonds up (and their yields down), causing them to offer a less favorable risk/reward trade-off than their lower-yielding counterparts.

IQ S&P High Yield Low Volatility Bond ETF HYLV attempts to improve risk-adjusted performance by targeting corporate bonds rated below-investment-grade with low risk relative to the junk universe. It won’t always keep pace with the market, but it should offer better downside protection and better risk-adjusted performance than the broad high-yield bond market over the long term. That said, this is still a risky bond investment and not a suitable replacement for investment-grade bonds.

The Low-Volatility Anomaly While there generally is a positive relationship between risk and return, that relationship isn't linear. Securities with lower risk, as measured by sensitivity to market fluctuations--beta--or volatility, have historically offered better risk-adjusted performance than their more volatile counterparts. This relationship has been observed in both the equity and fixed-income markets. It likely exists because many investors prioritize return over risk-adjusted performance. But that means risk comes off the table more quickly than returns, creating an attractive opportunity for those who prefer to take less risk.

Low-volatility investment strategies have been successfully applied to stocks for years, but it is more challenging to apply the concept to the bond market. Most bonds don’t trade as frequently as stocks, so past volatility could understate their true risk. A volatility screen could bias a portfolio toward bonds that don’t trade often, as they may appear less volatile than bonds with more regular trades. Volatility also declines as bonds approach maturity, so past volatility may overstate a bond’s likely future volatility. And selecting bonds with low volatility would bias a portfolio toward short-duration securities. Finally, past volatility doesn’t pick up changes in risk as quickly as market prices, though the same could be said for equities.

Implementation To address these challenges, the fund ignores past volatility in its selection process. Instead, it relies on forward-looking information to target lower-risk bonds using a measure called "marginal contribution of risk." This measure is calculated as the difference between a bond's option-adjusted spread and the adjusted average OAS for the selection universe times the bond's spread duration. The first part of this calculation captures the market's view of the bond's current credit risk relative to the selection universe, while the spread duration captures the bond's sensitivity to changes in credit spreads.

Putting these two pieces together provides a more holistic picture of a bond’s credit risk. And it should detect deteriorating credit quality much more quickly than credit ratings or past volatility, as it incorporates OAS (that is, yield). Investors don’t wait for the credit rating agencies to say that credit quality has deteriorated to demand higher yields when the fundamentals have weakened. It is important to note that the marginal contribution of risk metric ignores absolute duration, so the portfolio shouldn’t have a built-in bias toward short-duration bonds.

Each month, the fund’s index, the S&P U.S. High Yield Low Volatility Corporate Bond Index, ranks the bonds from its liquidity-screened selection universe (the S&P U.S. High Yield Select Corporate Bond Index) on their marginal contribution of risk and selects the lowest-ranking (least risky) 50% by count. To mitigate unnecessary turnover, existing constituents may stay in the portfolio if they rank in the lowest 60%. It then weights its holdings by market value, subject to a 3% issuer cap. This weighting approach, coupled with the turnover buffer, helps mitigate transaction costs. And the fund’s broad reach effectively diversifies risk.

Not surprisingly, the fund has a significant bias toward BB rated bonds, the highest rung on the high-yield bond ladder. At the end of May 2019, BB bonds represented about 83% of the portfolio. By comparison, similarly rated bonds currently account for about 51% of iShares iBoxx $ High Yield Corporate Bond ETF HYG. As a result, the fund tends to offer a lower yield than HYG, so it probably won’t keep pace when credit spreads are steady or tighten. But it should hold up better when spreads widen, which typically happens in tough environments.

Performance This fund was launched in February 2017, so it has a limited record and a small asset base, which can make it expensive to trade. It has gotten off to a slow start, lagging HYG by 86 basis points from inception through June 2019. But as expected, it exhibited lower volatility and tended to hold up better during market downturns than that benchmark. Still, it posted less attractive risk-adjusted performance (as measured by Sharpe ratio) over its short life.

As far as strategic-beta bond funds go, this is one of the more promising. It relies on forward-looking information to dial down risk while preserving diversification and taking steps to mitigate transaction costs. As an added benefit, its 0.40% expense ratio is among the lowest in the high-yield Morningstar Category and is slightly lower than HYG’s. This fund is worth keeping on your radar.

Alternatives Xtrackers Low Beta High Yield Bond ETF HYDW is a slightly cheaper (0.25% expense ratio) but less compelling alternative. It targets high-yield corporate bonds with lower yields than the median bond in their respective sectors. This is a less holistic measure of risk than what HYLV uses because it doesn't consider how sensitive bonds are to changes in credit spreads.

Silver-rated Vanguard High-Yield Corporate VWEHX (0.23% expense ratio) is also worth considering. This actively managed strategy favors higher-quality junk bonds.

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