There has been a remarkable trend lately among exchange-traded funds invested in high-yield bonds — dramatic outflows of cash. High-yield bond funds recorded $1.9 billion in outflows for the week ending May 11, with 90% coming from ETFs, according to Morningstar. That number was $1.3 billion for the week before, with ETFs accounting for all of the outflows in the category. That comes after massive inflows into the asset class earlier in the year, with an expanding role of ETFs.
It’s true that no other asset class has experienced more volatility in flows or performance this year than high yield. The rocky momentum began building last fall, when Third Avenue Management, with the now-collapsed Focused Credit Fund, and other distressed high-yield fund firms reported they were struggling to respond to investor redemptions.
So, why the attention on ETFs? We know, according to Morningstar, that the year-to-date infusion into high yield is $13.84 billion, with 39% of that in ETFs. We also know that the extreme swings in flows into and out of high-yield bond products, and particularly ETFs, create a high cost of trading. Bonds, like stocks, trade in the secondary market between investors.
Source: Morningstar Direct, as of 4/30/2016.
However, unlike equities that trade on exchanges, bonds require expertise. According to specialist traders of high-yield credit, ETFs cannot compete in this specialty space because the bid/ask spreads required to handle redemptions and purchases erode principal every time there is a swing from inflows to outflows. High-yield bonds trade in the over-the-counter market, a dealer network not centralized on exchanges that often lacks transparency into dealer transactions and inventory, making it very difficult to accurately replicate a benchmark. In addition, high-yield bonds have some of the highest spreads in the fixed-income market, reflecting the risk premium of the asset class, with the potential of default rates expected to increase as interest rates move higher. As a result, high-yield bond ETFs are serially underperforming the benchmarks they are supposed to track due to the drag of trading costs.
We can see this play out with one of the largest ETFs in the high-yield category, the iShares iBoxx High Yield Corporate Bond ETF (HYG), which has underperformed the iBoxx Liquid High Yield Index, the stated benchmark it tracks, by -1.44% since the start of 2016. The fees associated with passive strategies like the iShares fund make it difficult for them to match the returns of their index. Over time, the performance divergences between high-yield passive strategies and their indexes are likely to grow as the cumulative costs mount.
Finally, passive strategies may have limited exposure to the entire high-yield market due to the liquidity constraints of the category. Given the lack of market transparency, many passive strategies use market sampling, which excludes smaller bond issuances and doesn’t accurately capture large parts of the market. Smaller size issuers can offer attractive investment opportunities for active managers that have the flexibility to invest along the credit spectrum and have the necessary credit analysis capabilities. According to data from JPMorgan, more than $1.9 trillion of new high-yield bond issuance occurred between 2008 and 2014. Of this amount, just over 15%, or $290 billion, was issued by companies in the energy sector. This credit boom from energy companies to finance expansion efforts has caused the high-yield energy sector to grow from 10% of the Bank of America Merrill Lynch High Yield Master II Index at the end of 2007 to nearly 15% at its peak in 2014. For perspective, the energy sector of the S&P 500 Index was only at 8.4 percent at the end of 2014. As a result, as oil prices began to fall in the second half of 2014, high-yield issuers concentrated in the energy sector saw the worst performance of any bonds in the market, only to be followed by the best performance this year, exceeding emerging market debt returns through April, as oil prices found support and began to recover.