High-yield bond ETFs offer attractive risk/reward profile

Oct 18th, 2011 | By | Category: Fixed Income

With interest rates at historic low levels, investors searching for yield over the past year have been moving into high-yield corporate bonds, and many bond funds specialising in this sector have seen their assets swell.

While default rates may rise moderately, they are likely to remain well below the historical average of 4.7%, with Moody’s forecasting less than 3%.

However, the correction in high-yield bonds during the third quarter of this year unnerved many investors and led some to head for the perceived safety of government bonds. But unless you think we are heading for a repeat of the 2008/9 financial crisis, the sharp decline in high-yield prices could represent an attractive buying opportunity for investors willing to take more risk within their fixed income portfolios for potentially higher returns.

If slow growth and steady inflation persists through the rest of 2011 and into 2012, high-yield bonds can continue to generate attractive returns, especially if the euro crisis shows signs of improvement.

Indeed, the fundamentals for high-yield remain strong supported by a compelling backdrop of low interest rates and record low default rates; despite the ‘doom and gloom’ sentiment in market, the risk profile of the corporate high-yield market has improved significantly since 2008.

The weakest high-yield companies defaulted in 2008 /09 and have not returned to the market. Moreover, new issuance within the investible universe over the past two years has been primarily of higher-rated credits. So while default rates may rise moderately over the next few years, they are likely to remain well below the historical average of 4.7 per cent with Moody’s forecasting less than 3 per cent.

This improvement in credit profile is not just a function of the weakest names having already defaulted, but a reflection of the exceptionally strong balance sheets of many issuers. Companies that survived the credit crisis aggressively deleveraged and built up large cash balances. According to data from the US Federal Reserve, non-financial S&P 500 companies have more cash on their balance sheets than at any point in the past 58 years; it’s a similar story across Europe and Asia.

Yet despite the fundamentals, the valuations of high-yield bonds are such that they are factoring in a fully pessimistic macro outlook and taking little consideration of corporate strength. So with the market continuing to price in an excessive default rate for the asset class, the superior risk/reward profile versus other credit products becomes interesting. In short, the recent market correction could represent an attractive buying opportunity for investors.

High-yield bond ETFs worth further investigation include:

Lyxor ETF iBoxx EUR Liquid High Yield 30
The Markit iBoxx EUR Liquid High Yield 30 Total Return index includes 30 of the most liquid bonds making up the Markit iBoxx EUR High Yield Core Cum Crossover index, representing the scope of high-yield, Euro-denominated non-government bonds. As of 30th September 2011 the fund had a yield of 9.4%.

iShares Markit iBoxx Euro High Yield Bond
The Markit iBoxx Euro Liquid High Yield Index offers exposure to the largest and most liquid Euro denominated corporate bonds with sub-investment grade rating. Only bonds with a minimum amount outstanding of €250 million are included in the index. The maximum original time to maturity is 10.5 years and the minimum time to maturity is 2 years for new bonds to be included (no minimum restriction for bonds already in the index). For diversification purposes the weight of each issuer in the index is capped at 5%. As of 30th September 2011 the fund had a yield of 7.8%.

iShares Markit iBoxx $ High Yield Capped Bond
The Markit iBoxx USD Liquid High Yield Capped Index consists of the most liquid US Dollar denominated corporate bonds with a sub-investment grade rating, while maintaining a focus on UCITs eligibility. The maximum original time to maturity is 15 years and the minimum time to maturity is three and a half years for new bonds to be included and three years for bonds that already exist in the index. For diversification purposes the weight of each issuer in the index is capped at 3%. As of 30th September 2011 the fund had a yield of 8.7%.

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