High yield soars in low-rate world

With Treasury yields seemingly setting new record lows every day, financial advisers increasingly are turning to high-yield bonds as a way to make up for the lost income stream.

But what is the best way to invest in high yield: through mutual funds or exchange-traded funds? It turns out that as with other asset classes, there are pros and cons to each.

The allure of high-yield bonds is relatively simple to understand. The yields on 10-year Treasuries are hovering around 1.5%, and the rate on the 30-year Treasury is about 2.55% — so low that they have some money managers worried that one bad day of trading could wipe out a single year’s coupon.

Investment-grade-credit corporate bonds haven’t offered much better options. Investment-grade issuers have been rushing to refinance at current rates to lower their borrowing costs.

In July, $58.9 billion of investment-grade corporate bonds were issued, a one-month record, according to Dealogic, which tracks capital markets data as far back as 1995. International Business Machines Corp. was among the issuers, selling 10-year bonds with a yield of 1.88%, a record low for an investment-grade bond of that maturity.

With those ultralow yields in mind, investors poured more than $6.2 billion in new money into high-yield-bond ETFs over the first six months this year, compared with just $1.6 billion a year earlier. In fact, 42% of the high-yield-ETF category’s $27 billion of assets were invested in the 12-month period through June.

Despite that growth, high-yield-bond ETFs are dwarfed by high-yield-bond mutual funds, which had $16 billion in new flows through the first half of this year and have $227 billion in total assets.

The bulk of the ETF inflows have gone into the two biggest high-yield ETFs, iShares’ $15 billion iBoxx High Yield Corporate Bond ETF (HYG) and State Street Corp.’s $10.9 billion SPDR Barclays Capital High Yield Bond ETF (JNK). Both have yields over 7%.

BONDS PAY “HANDSOMELY’

Tom Lydon, president of Global Trends Investments, is overweight high-yield bonds.

“While equity markets are trying to work out of this economic hangover, you can get paid very handsomely in the high-yield market,” he said. “What you’re paid today in high yields, compared to Treasuries, is very rewarding.”

Mr. Lydon’s outlook for high-yield bonds is a rosy one, even with the aforementioned economic hangover’s drag on companies.

“It’s a different world than it was in 2008, when high-yield bonds got creamed by the financial crisis,” he said. “We haven’t seen as much volatility in high yield as we have in equities.”

Part of the reason that there has been less volatility is that the financial crisis forced a lot of high-yield issuers to clean up their balance sheets, and the current rates have allowed them to refinance at lower costs, albeit nowhere near as low as investment grade issuers.

The benefit of using high-yield ETFs instead of mutual funds is that if things do start to head south again, the liquidity of the ETFs will allow investors to get out quickly, Mr. Lydon said.

With mutual funds, investors have to wait until the end of the day to receive their redemptions, and if there is a lot of selling, the mutual funds could be forced to sell into an illiquid market to meet withdrawals.

However, advisers have to be careful about buying and selling high-yield-bond ETFs, much more so than with most other equity and fixed-income ETFs.

AS LIQUID AS HOLDINGS

ETFs really are only as liquid as their underlying holdings, and high-yield bonds are one of the more illiquid asset classes, said Timothy Strauts, an ETF analyst at Morningstar Inc.

He warned that in times of heavy volatility in the high-yield-bond market, ETFs experience significant swings in premiums and discounts, which means that the shares trade either higher or lower than the ETF’s net asset value. When there is a rush to the exits, the ETFs could swing to discounts, which means their shares trade at less than the NAVs of bonds.

Because demand for the ETFs has been strong, they have been trading at premiums recently. Both the biggest high-yield ETFs, in fact, closed July 30 with premiums of more than 50 basis points, meaning that shares were trading at higher prices than the NAVs of the underlying securities.

The iShares iBoxx High Yield Corporate Bond ETF typically trades at a slightly higher premium than its SPDR counterpart because it is more conservative regarding which bonds it will take to create new shares, Mr. Strauts said.

The premium is a result of iShares’ externalizing the transaction costs of buying new bonds, said Matt Tucker, head of iShares’ fixed-income team.

“Each investor is paying their own costs and won’t see any negative impacts from the actions of other shareholders,” he said.

In mutual funds, the transaction costs for buying and selling securities — when new money comes in or is withdrawn — is borne by all shareholders

The SPDR ETF has more flexibility in which high-yield bonds it accepts to make new shares.

However, the flexibility does create more tracking error, Mr. Strauts said.

The SPDR ETF has an estimated one-year holding cost of 1.34%, which essentially means that it fails to track its index by that amount, according to Morningstar.

The iShares ETF has a one-year holding cost of 0.13%.

“There’s a lot of benefits to using high-yield-bond ETFs, but there’s also a lot of work to do,” Mr. Lydon said.

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