High Yield Bond ETFs: Junk or Ready to Perform?

What should we call an asset class whose largest and most prominent ETF debuted 17 years ago, has reached $17 billion in assets, and has produced a price return of -26% in total since that time? 

Fortunately, I'm referring to high yield bonds and the iShares IBoxx USD High Yield Corporate Bond ETF (HYG). Because without that yield, I suspect we’d call that segment of the bond market a pile of junk.

But it does bring into question what investment advisors and self-directed investors should think of high yield bonds as an asset class in 2024 and beyond. And more importantly, if and how to position it in their portfolios. To use a boxing reference, let’s do a tale of the tape, a pros and cons regarding the asset class made famous, then infamous, by a pair of men name Milken and Boesky back in the 1980s.

HYG Lifetime Chart

Source: etf.com

Over time, this bond segment that offers higher yields than Treasuries and “investment grade” corporate bonds evolved dramatically. The market has reached the point where a small number of ETFs, including HYG and the $8.3 billion SPDR Bloomberg High Yield Bond ETF (JNK) are strong proxies for this market. So much so that when the US Federal Reserve was buying assets to support market stability multiple times since the 2008 crisis, it bought shares in those ETFs directly, rather than try to sift through the underlying bonds.  

ETFs Made High Yield Bond Investing More Efficient

The flip side of that situation is that high yields bonds may have transitioned from a “market of bonds” to a “bond market,” to steal a phrase from the equity market. In other words, they trade primarily in basket form, and a lot of price discovery has vanished.  

That’s not the fault of the ETF industry. It's more a reflection of how investments are selected. Security selection is still a profession and passion for many, but giant sums of money are just “indexing it” in the name of efficiency.  

For high yield bonds, that took it from a market where investors used to count on finding hidden gems, to one where it is getting tougher to find an edge. There are some solid ETFs like the $3 billion VanEck Fallen Angel High Yield Bond ETF (ANGL) and the $1.7 billion iShares Fallen Angels USD Bond ETF (FALN) which apply some proactive research measures to identify bonds that were once investment grade and may now represent “high-quality junk” securities. However, most public high yield bonds tend to be bought in baskets.  

That has some very positive features, if inflation, rising rates, a recession and/or concerns about bond market liquidity enter the picture. They already have, but the high yield space has been able to “Harry Houdini” its way out of the worst-case scenarios each time. That has led to some long dry spells for high yield returns, but for those who can close their eyes and just count the income, it has worked out.

T-bills Now a High Yield Bond ETF Rival

Because while that 17-year run in which HYG lost 26% in price doesn’t sound great, the total return of HYG over that time is 117%, thanks to all the income that made it into investors’ pockets since the ETF’s 2007 inception. Of note, over that time frame, the yield on US 10-year Treasury bonds did a round trip, from 5% to nearly zero and back to 5% during last year’s fourth quarter. It stands at 4.5% currently.

HYG’s most recent five-year annualized return is around 2.9%, so a continuation of that type of performance could look quite poor in an era of 5% T-bill rates. Since the peak of the financial markets leading into the pandemic (2/19/2020), HYG has only managed a total return of 9% (not annualized). That was not an issue when short-term “worry-free” rates were nil, but it could be a major headwind if any one of the risks were to be realized.

But perhaps the biggest concern for high yield investors is that despite higher interest rates for US Treasuries, the spread over Treasuries for BB-rated bonds, the upper end of the junk market, is puny. At 1.85%, it is just below where it was in early 2020 and at a level not seen since May of 2007. That’s when the trouble started in the global financial crisis.

So, it is “buyer beware” time for high yield bond investors. And for financial advisors, this would be a good time to communicate with clients with exposure to this asset class and what the potential is, in both directions.