High Yield Bond ETFs Beating Equities in 2009

Rallying equity markets and zero interest rates are powering the largest surge in high yield bonds in a decade. High yield bonds, otherwise known as junk bonds, are considered speculative because they carry substantial default risk. The bet against default, a bet on company solvency, turned out to be one of the best in 2009.

The year didn't start out that way. In January 2009 the market assessed the risk of default at as high as 18%, a notch above the 16% rate achieved during the height of the depression in the thirties. Historically the default rate on high yield is 3-4% but the collapse of Lehman changed everything. As high yield bonds sold off, the yield on benchmark indexes surpassed 20%. As it turned out, default estimates proved too high. Estimates for bond default rate for 2009 are now below 10%. S&Ps latest forecast projects that the default rate will fall to 6.9% by September 2010.

The leading high yield ETFs, iShares iBoxx High Yield Corporate Bond (NYSEArca:HYG) and SPDR Barclays Capital High Yield Bond (NYSEArca:JNK) have more than doubled in size since January. A Powershares offering, PowerShares High Yield Corporate Bond (NYSEArca: PHB has also expanded but remains small. The chart below shows the return of HYG compared to an aggregate investment grade benchmark, iShares Barclay Aggregate Bond (NYSEArca: AGG) the benchmark Standard and Poor's Depositary Receipts (NYSEArca:SPY).

As the chart shows, these bond ETFs outperformed equities most of 2009.

What are their holdings? They hold low-rated (below BBB- ) speculative bonds with the potential to default. JNK usually has more speculative (higher yield) portfolio compared to HYG, B2 versus B1. Bonds in JNK include companies like GMAC, Harrah's, and IntelSat, an FRN (Floating Rate Note) issued by AIG. HYG holds paper from MGM Mirage, EchoStar, Hertz..

Why not stick with more reliable Federal Government Bonds, U.S. Agency bonds or high-grade corporate bonds issued by reliable trusted companies like McDonalds or General Mills? The reason is that compared to safer fixed income instruments speculative bonds simply pay more interest to compensate for the additional risk. As long as they don't default, it is worth it.

How much additional risk is implied in a typical high yield ETF portfolio? Additional risk is measured in terms of the probability of a bond defaulting and the recovery rate (the measure of principal recoverable should a bond default). Historically there is a 3-4% default rate and a recovery rate of 40%-50% on bonds, 70% on loans. But both the default rate and the recovery rate vary depending on the market climate. When defaults decline (or recovery rates rise) high yield bonds seem safer-- prices rise and yields fall. When defaults rise (or recovery rates fall), the opposite happens: to attract capital on new issues, yields rise and prices fall.

Where are valuations? Right now HYG yields about 10%, JNK yields about 12%. This is actually slightly lower than the long-term historic average of about 11-13%, which suggests that they are fairly priced, or a little expensive. But this is a little deceptive because treasury bonds pay so little right now. Historically high yield bonds pay about 5% more than treasury bonds. Currently these ETFs are yielding 7%-9% above treasury yields. This is still above the historic average, so on that basis high yield looks historically cheap. Of course any increase in interest rates will not be good for any fixed income investment, including high yield ETFs. High yield returns can also be compared to equity. Historically returns on high yield more closely resemble equity than other fixed income. Because high yield has outperformed equity, it looks expensive in relation to equity.

Why are ETFs a possible solution? Traditionally investors have had just two choices for exposure to the high yield asset class: individual bond ownership and ownership of a mutual fund holding portfolios of high yield bonds. Ownership of individual bonds can be problematic because many of the individual bonds in the sector are illiquid and because small investors typically pay more when purchasing a single bond compared to professionals who buy frequently and in size. Another problem with individual bond ownership is that it can be harder to properly identify and diversify risk. Concentrated risk in just a few names increases the potential for losses.

How do ETFs compare to mutual funds? Exposure to high yield debt through mutual funds mitigates some of these problems but creates new ones. Most mutual funds charge investors a hefty expense ratio that cuts into returns. HYG charges 0.5%. JNK charges investors just 0.4%. This compares to typical mutual fund rates of between 1% and 2%. ETFs also tend to have lower turnover, which also reduces costs. Turnover on JNK for example is about 20% annually compared to about 100% on average for a mutual fund, with some funds as high as 2000% or more annually. High yield ETFs now tend to be more popular than equivalent mutual funds. HYG holds close to four billion dollars in capitalization and has an average trading volume of around 750,000 shares, compared to 20,000 or 30,000 for the average mutual fund.

ETFs offer a better solution, but not a perfect one. One problem with high yield ETFs is that ironically their very popularity can bring new risks for investors. HYG for example trades 7% or more above the fund's Net Asset Value (NAV). Also, the market for high yield bonds is far smaller than treasuries so individual holdings may at times be illiquid or unavailable. This effect tends to be a bigger factor when high yield markets are volatile and move away from historic norms. And this tends to increase NAV. But in terms of high yield funds, alternatives to ETFs such as Closed End Funds (CEFs) holding high yield debt tend to trade even further from NAV-- 20% or even more, but in the case of CEFs, more typically below NAV.