Most successful high yield managers tell us that the key to performing well over the long term is to avoid companies that go bankrupt. Of course, at its broadest level this is self-evident for bond investors but in an asset class where a material default rate is to be expected and where the high levels of leverage in companies can mean they unwind very quickly, it is far from easy to achieve in practice. Those managers who can achieve a low level of “adverse credit events”, collecting sustainably high coupons from their holdings while avoiding the periodic illiquidity of the asset class, are therefore those who typically perform strongly.
These characteristics of high yield make it very dependent on a series of idiosyncratic credit risks and I am therefore surprised by the rapid rise of dedicated ETFs in the US. Not only does blind replication clearly remove a key plank of how high yield bond managers add value (hopefully a conscious decision when selecting a pure beta strategy) but by its very nature, it is a very difficult market to replicate by sampling and yet the illiquid nature of many issues means that full index replication is costly. This underlying illiquidity of many bonds is an increasing problem as investment banks continue to withdraw capital from fixed income markets and thus focus more and more on matching buyers and sellers.
Many ETFs, such as the SPDR Barclays Capital High Yield Bond fund attempt to address these concerns by focusing only on the most liquid issues but even here, liquidity is relative and it is noticeable that the NAV of the fund has lagged the benchmark materially over time. Moreover, the focus on larger, liquid issuers is of course an interesting concept in the world of bonds given that it implies a greater focus on companies with a higher absolute level of debt. This does not automatically imply higher leverage but companies with large debt burdens do at times come under particular pressure, especially if they face more regular refinancing requirements.
In the event that ETFs remain a popular way to buy high yield, a key question is how this might affect the outcome from active funds. The most probable answer is even higher volatility in the more liquid names in the index due to the price-insensitive nature of ETF activity. While this technical-driven volatility could create buying and selling opportunities for the more nimble managers, investors should be aware that it might at the margin make for an even bumpier return profile from what is already a volatile asset class.