There seems to be a persistent school of thought that high yield bond ETFs do not work. I would say that they are ignoring the evidence that high yield ETFs in general have tracked pretty well, especially when you consider the ETFs’ high fees and the nature of the underlying market. While nothing is ever a given, there are three key things that portfolio managers can do to help take some of the sting out of the fees, as well as other impediments to performance.
One of the biggest hurdles to high yield ETFs’ performance are the high transaction costs in the market. Bid offer spreads have varied over the last 10 years from 1% in the aftermath of the financial crisis to about 0.4% today. SPDR estimates that transaction costs amounted to about 0.52 basis points a year over the period 2013-17 for their huge JNK ETF in the US.
The first key thing that a high yield ETF portfolio manager can do is make sure that their ETF is benchmarked to a realistic index. The ETF issuers often work to construct bespoke indexes to ensure that only the larger, more liquid bond issuers are included. Difficult bonds, such as contingently convertible bonds, are usually excluded. Some ETF issuers have been perceptive enough to incorporate slippage due to transaction costs in their indexes, others not. This does not necessarily add economic value, but it does have cosmetic value.
The second key thing an ETF portfolio manager can do is play in the new issue market. New issues often come to market at a small discount. New issues will not immediately go into the ETF benchmark, but taking a position in a new, off benchmark bond allows the portfolio manager to get it cheaply at issue, and prevents churn if and when the bond does go into the benchmark at month end. I have seen various estimates about how much value this strategy can add, but let’s say that it adds approximately 0.25% a year of value, assuming a portfolio manager does this in a judicious way and that she has a little bit of luck and skill.
The third key thing a portfolio manager can potentially do to add value is to lend bonds from the ETF. There is quite an active market in high yield bond lending, although not all issuers will do this. This can add another 0.15% to 0.2% to the returns of an ETF. Blackrock reports up to 30% of the bonds in their ETFs can be out on loan at any one time.
I am sure that high yield portfolio managers will feel that I have grossly over simplified their very complex role, but high yield ETFs have been around since 2007 and they have, on the whole, performed pretty much as they say on the tin. For sure, the best of them have had to use one or two tricks of the trade to match the index, but allowing for fees, I think they have done a pretty good job. All we have to do now is to get those fees down a little.
High yield bond ETFs with a 5 year track record
| ETF Name | Fee | 5 year Performance ETF | 5 Year Performance Benchmark | Average annual tracking difference after fees |
| iShares iBoxx $ High Yield ETF | 0.49% | 23.12% | 25.96% | -0.08% |
| SPRD Bloomberg Barclays High Yield Bond ETF | 0.40% | 21.18% | 28.47% | -1.06% |
| iShares EUR High Yield Corp Bond Ucits ETF | 0.50% | 24.04% | 26.86% | -0.06% |
| SPDR Bloomberg Barclays Eur High Yield Bond Ucits ETF | 0.40% | 28.17% | 32.09% | -0.38% |
| Pimco Short-Term HY Corp Bond Source Ucits ETF | 0.55% | 26.01% | 28.83% | -0.01% |
