Exploring The Hidden Risks Of High Yield ETFs
Alexander Pearson: When the high-paying low-credit instruments that we used to call ‘Junk Bonds’ were first labelled as “High Yield” and packaged into ETFs, it was easy to set aside the racketeering escapades of 80s bond kings like Michael Milken and believe that we were being presented with a great opportunity to invest in a moderated, pasteurized instrument with managed risks and the tempting potential of outsized returns.
High yield corporate bonds have been the rock stars of the bond ETF space, delivering excellent performance and seemingly low risk until just over a year ago, when things started to unravel. The AdvisorShares Peritus High Yield ETF (NYSEARCA:HYLD), an actively managed ETF, was among those hit the hardest.
HYLD is not a passive, index-tracking fund; the fund’s management carry out due diligence on all the corporate bonds the fund invests in, and this is accompanied by an active style and high expense ratios. Theoretically, HYLD should produce superior returns provided that the underlying bonds don’t default.
HYLD’s Investment Strategy
The philosophy that underpins the fund’s active management strategy is interesting: by focusing on illiquid securities in secondary markets, where pricing inefficiencies can prevail, HYLD’s managers believe that it is possible to realize a high yield income stream. In large part, this investment philosophy is what accounts for HYLD’s hyper-active style.
The AdvisorShares prospectus describes the strategy thus:
Peritus takes a value-based, active credit approach to the markets, primarily focusing on the secondary market where Peritus believes there is less competition and more opportunities for capital gains. Peritus de-emphasizes relative value in favor of long-term, absolute returns.
With exposure to these illiquid corners of the market, the fund’s portfolio is surprisingly well diversified, and is should be immune to any single-sector shock or collapse. The chart below shows the fund’s varied exposure across market sectors.
However, one of the more worrying aspects of this approach though is this: a fund that seeks alpha entirely in inefficiently priced markets is by definition one that lies at the mercy of the types of inefficiencies that give rise to concentrated risk.
So how well has this strategy worked, and what went wrong in 2014?
Since its inception in October 2010 until September 2014, HYLD produced solid returns, often beating the Barclays Corporate High Yield Index. This performance led to an influx of investors in the ETF at a time when Stock Index returns were beginning to flag, and seemed to support the active strategy that its managers were pursuing.
In the final quarter of 2014, however, returns plummeted as concentrated risk came to call in the form of parallel corporate defaults. Since then, HYLD has demonstrated little ability to recover and has trailed all the comparable benchmarks (albeit without further expanding the gap between them). In many ways, a chart of the fund’s NAV resembles the performance of a flawed option-writing fund, with steady and consistent growth punctuated by sporadic, devastating declines: this is also an apt way of interpreting the risk of high yield found here.
Paying for Risk
Because HYLD invests almost exclusively in illiquid securities, it also has a high expense ratio (1.23 through 2015). Because liquid bonds are more heavily traded the process of price discovery is generally more efficient, so the market helps to balance the risk/return profile of any ETF investing in them.
But for HYLD, with the additional risk comes additional costs. While ever the fund management’s ability to successfully evaluate and select assets to invest in prevails, then the exceptionally high yields will more than offset the additional expense. But as soon as this strategy, which is necessarily aggressive in order to capitalize on potentially high reward opportunities, backfires, then investors in the ETF are going to see substantial losses of the kind that late 2014 produced.
The Dark Side of High Yield Credit Risk
Where investors in stocks may vacillate between capital growth and dividend income, the bond market has always been about one thing: yield. Yield is the principal income that swells the value of an ETF such as HYLD. The class of sub BBB- rated company bonds that HYLD includes in its portfolio (of which 1.19% are not rated) pay high coupon rates, but more importantly they offer phenomenal yield to maturity.