An ETF for Exposure to Short-Term High-Yield Bonds

IShares 0-5 Year High Yield Corporate Bond ETF SHYG is a decent choice for exposure to U.S. high-yield corporate bonds. However, high-yield bonds are tough to index well because they are thinly traded. The fund is cheaper than most high-yield bond Morningstar Category peers, but it has trailed its benchmark by a multiple of its fee since inception, and it isn't representative of how its actively managed counterparts invest. These limitations support a Morningstar Analyst Rating of Neutral.

High-yield bonds are illiquid and expensive to trade, which can make them hard to index efficiently and can lead to high tracking error as some bonds may not be available. To address this issue, this fund screens its holdings for liquidity by their size. The fund tracks the Markit iBoxx USD Liquid High Yield 0-5 Index, which provides market-value-weighted exposure to high-yield corporate bonds with fewer than five years remaining to maturity. However, that also restricts it to a narrower universe than is available to many of its active counterparts, and it does not represent the investment opportunity set available to active managers.

Active managers can also take advantage of mispricing, which is likely more common among high-yield bonds than it is in other markets. A portion of the risk premium associated with high-yield bonds stems from illiquidity risk, so this fund misses out compared with active peers that can delve into smaller illiquid bonds. So, this fund's cost advantage may not translate into strong category-relative performance.

High-yield bonds are expensive to trade, which can lead to high transaction costs for index funds, which prioritize index tracking above all else, and result in higher tracking error than the investment-grade corporate market. This portfolio partially mitigates these costs by leaning toward the largest issues in the market. The portfolio management team at BlackRock has kept the fund close to its index despite the underlying junk-bond market's illiquidity. From the fund's October 2013 inception through May 2019, it trailed its benchmark by 25 basis points annually, less than its 0.30% expense ratio.

Fundamental View High-yield bonds have considerable credit risk. However, they attempt to compensate investors for their default risk with enticing coupons. Even if issuers don't default, high-yield bonds can underperform the broader bond market if credit spreads widen, which usually occurs during economic downturns.

This fund has only modest interest-rate risk. This portfolio's focus on short-term bonds slightly reduces its interest-rate risk compared with iShares iBoxx $ High Yield Corporate Bond ETF HYG, which tracks the broader universe. Credit risk is the primary return driver for this fund.

High-yield bonds are expensive to trade. To reduce transaction costs, this index portfolio screens its holdings for liquidity. However, this screen leaves out a portion of the universe that is available to active managers. The fund further tilts toward the largest and most-liquid issues through its market-value-weighting approach. While it helps reduce implementation costs, this approach can lead to unintended sector concentration. The fund does not take any steps to manage liquidity or credit risk, but it harnesses the market's collective view about the value of its holdings at a low cost.

BlackRock's index-management group has produced a decent index-tracking record, but it still faces a challenge from the illiquidity of the high-yield market. From the fund's October 2013 inception through May 2019, it trailed its benchmark by 25 basis points annually, less than its 0.30% expense ratio. This is evidence of high-fidelity tracking performance produced by the portfolio management team.

Though it has some shortcomings, the fund has two aces up its sleeve. First, its cost advantage will continue to give it a durable edge. Second, it removes bonds that have fallen more than 40% from their initial issue prices to mitigate drawdowns. As a result of this rule, the fund eliminated approximately 50 energy sector bonds between April 2015 and April 2016. It fared better than most of its peers during the commodity sell-off that lasted from mid-2015 to early 2016. On average, its category peers declined by 8%, while it lost 6%.

Portfolio Construction For this risky, illiquid corner of the bond market, active management is likely a better route than index investing. This supports a downgrade of its Process Pillar rating to Negative from Neutral. The fund seeks to track the Markit iBoxx USD Liquid High Yield 0-5 Index, which is designed to reflect the performance of U.S.-dollar-denominated high-yield corporate debt. High-yield bonds are generally rated below investment-grade. The index offers exposure to liquid high-yield U.S. corporate bonds maturing between zero and five years. Only bonds with a minimum of $350 million in face value are included. The index uses a market-value-weighted methodology with a cap on each issuer of 3%. The index is rebalanced each month.

Fees SHYG's 0.30% fee gives it a sustainable competitive advantage, supporting its Positive Price Pillar rating. This fee is lower than 92% of funds in the category. Finally, from its inception through May 2019, the fund has lagged its benchmark less than its fee.

Alternatives Neutral-rated SPDR Bloomberg Barclays Short Term High Yield Bond ETF SJNK (0.40% expense ratio) is SHYG's closest competitor. This fund tracks the Bloomberg Barclays U.S. High Yield 350mn Cash Pay 0-5 Yr 2% Capped Index, which provides market-cap-weighted exposure to junk bonds with five years or fewer remaining until maturity. Its duration tends to be on par with SHYG's.

SPDR Bloomberg Barclays High Yield Bond JNK and HYG target a wider universe of high-yield bonds across the maturity spectrum. Both funds currently have Neutral ratings.

JNK follows the Bloomberg Barclays High Yield Very Liquid Index. More than 13% of its assets are currently invested in the CCC or lower bucket, resulting in an SEC yield of 5.76% as of late June 2019. JNK's fee is 0.40%. HYG (with a 0.49% expense ratio) employs sampling to track Markit iBoxx USD Liquid High Yield Index. Just over 10% of HYG's holdings are in the below-CCC category. This fund currently offers an SEC yield of 5.40%.

Loomis Sayles High Income Opportunities LSIOX is Morningstar's top choice in the category. A seasoned team and well-executed approach support the fund’s Gold rating. That said, this vehicle is only available to approved institutional investors and those in certain wrap-fee programs.

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