High-Yield ETF Set To Follow Index Changes

July 06, 2009


What’s In Store

The changes of the index construction are designed to better represent the very liquid portion of the U.S. high-yield category. Markit will continue using liquidity as a gatekeeper for the index and the subsequent ETF as the index is expended and updated.

The index uses a liquidity measure to gauge each bond issue’s liquidity. Based on that liquidity measure, bond issues are included or excluded for the index if they meet other inclusion rules.

Formerly, the index used only the highest credit rating to determine candidacy in the index from the three credit rating companies. That excludes bonds having a rating of low investment grade by one credit rating agency, and subinvestment grade by others.

The new methodology will use an average rating, which will allow those bonds with a split rating of low investment grade and junk to be included. The effect of using this average rating will allow a broader representation of high-yield bonds, diversified among credit qualities.

The index will continue to exclude those bonds that have default warnings from Moody’s or “D” ratings from S&P or Fitch.

Among high-yield ETFs, HYG is already one of the most diversified, despite its previously low number of 50 issues in its portfolio. Varying the fund’s allocation broadly among the different credit qualities should enhance that broad-based profile, allowing the index to continue to be spread widely among the junk bond credit qualities.

Shifting Away From Equal-Weighting

Markit plans on opening the index up while limiting any single bond from becoming more than 3% of the overall portfolio. This seems to be an important aspect to note considering the higher default rates that often are not reflected directly in credit ratings.

When investing in high-yield bond indexes, overconcentration to a small number of bonds or sectors may be risky.

The index will also be changing its weighting of bonds from equal-weighted to market-value weighted, which is what makes it necessary to maintain a cap of 3% for any one bond issuer.

Although the index is set to rebalance on a monthly basis, a market profile will be taken annually for the index to set sector allocations represented in the index. For the first time, financial bonds will be added to the sectors, which include: consumer goods, consumer services, industrials & materials, telecommunication and technology, and utilities and energy.

With the old method, bonds included for each sector group varied depending on the market profile that was taken annually in November of each year. This new breakdown of sectors—with the inclusion of financial bonds—will increase the minimum level of bonds’ value outstanding for inclusion, from $200 million to $400 million.

These changes are already being put in place. By the end of last week, HYG held 84 bonds. In the next several months, we should expect to see an even more liquid and diversified way to gain exposure to a growing junk bond market.

Kyle Waller is a research analyst at Wiser Wealth Management in Marietta, Ga. He welcomes comments and suggestions for future columns at: [email protected].


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