From the May 2013 issue of Investment Advisor • Subscribe!

Don’t Ignore the Risks of High-Yield and Senior Loan ETFs

Over the past few years, investors have poured money into ETFs that track below-investment-grade debt indexes, with net inflows in high-yield and senior loan ETFs totaling over $22 billion during the three-year period ending on March 31, according to Bloomberg.

During that stretch, investors in these ETFs fared well due to gradually improving credit conditions, with fixed-rate high-yield investors also benefitting from persistently low interest rates. Looking ahead, however, the inability of index-based high-yield and senior loan ETFs to implement risk management techniques may leave investors exposed to significant risks when credit quality deteriorates or, in the case of high-yield corporate bond ETFs, when interest rates increase.

Unlike actively managed ETFs, most high-yield bond and senior loan index ETFs track passive benchmark indexes that allocate capital based on the market value of index constituents’ outstanding debt. In other words, the more indebted a company is, the greater its weight in the ETF’s underlying index. While this sort of market-value weighting scheme may be useful for constructing a benchmark index, it’s less logical for constructing an investment portfolio, particularly when it comes to risk management. After all, companies that issue more debt are not necessarily better positioned to repay that debt.

Senior loans tend to carry very little interest rate risk since they are typically structured as floating rate instruments whose interest payments increase or decrease based on the movement of a reference rate, such as LIBOR. On the other hand, while high-yield corporate bonds tend to be less sensitive to interest rates than investment-grade bonds, investors should not conclude they are immune from interest rate risk. Wider credit spreads over U.S. Treasuries than investment-grade bonds are the primary reason high-yield bonds tend to be less sensitive to interest rate movements. This, however, does not eliminate interest rate risk, particularly when credit spreads have already substantially narrowed in advance of interest rate increases. In such environments, high-yield bonds may be more sensitive to rising interest rates than investors expect. While active managers may utilize certain tools to mitigate interest rate risk, these tools are generally not utilized by index-based high-yield bond ETFs.

The diversification provided by both high-yield bond and senior loan index ETFs helps to mitigate issuer-specific risk; however, diversification alone is insufficient for managing the credit risk to which investors in these ETFs are exposed. From 1920 to 2011, the average annual default rate for BB- and B-rated bonds was 1.07% and 3.42%, respectively, while the annual default rate for CCC-rated bonds averaged 13.77% over the same time period, according to Moody’s. Investors may benefit from owning certain CCC-rated securities due to the relatively high yields such issues may offer, along with potential price appreciation if fundamental improvements are on the horizon. However, in light of the historical volatility associated with CCC-rated credits and their respective default rates, the risk of investing broadly in the lowest quality category of high-yield bonds, without additional credit analysis, typically outweighs the benefits, in our opinion. On the other hand, while index-based approaches have little flexibility in determining portfolio holdings, actively managed ETFs may choose to avoid owning bonds from certain issuers, industries, regions, etc., based on an assessment of overall risk and relative value.

There are many good reasons to include below-investment-grade bonds and senior loans in a well-diversified portfolio. In addition to offering relatively attractive yields, the current environment of modest growth with low default rates and generally sound corporate health supports below-investment-grade credit performance. Moreover, while credit spreads have steadily narrowed over the past 18 months, we believe investors are still being fairly compensated for taking credit risk. Looking forward, however, as economic conditions evolve, investors may benefit from reevaluating positions in these ETFs in favor of actively managed strategies that may be better equipped for risk management.

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