High-flying junk bonds are becoming a popular option for ETF investors. But the biggest of the lot is undergoing a sort of metamorphosis.
A popular benchmark tracking high-yield bonds is being tweaked. The result is that the biggest exchange-traded fund by assets, the iShares iBoxx High Yield Corporate Bond ETF (NYSEArca: HYG), should become more diversified and a bit more liquid.
The changes came on June 30 and involved underlying methodologies of the Markit iBoxx Liquid High Yield Index. The index changes come as many developments have occurred in the high-yield bond market since the index’s inception. According to Markit, the high-yield market has doubled in the past 10 years. Such increased size has given the so-called “junk” bond market a different profile and breadth, says the index provider.
In the old process, the index equal-weighted 50 high-yield issues limited to and within certain sectors. Under the new rules, 200 liquid bond issues will be included in the mix.
Tweaking For Diversity
High-yield bonds are issued by highly leveraged companies or companies in distress. Both situations make the bond holder demand a much higher yield and total return for the risks of default. Since the bonds are issued by such companies, higher-than-average volatility can be expected.
The chart below shows the risk and return characteristics of the iBoxx Liquid High Yield Index against two other common benchmarks over the last five years.
Source: Morningstar (7/1/2009)
Historically, the yield of this subinvestment-grade index has been significant. Taking a look at the year-over-year difference in total return and price return, we find that regarding calendar-year yields from 1999 through 2008, the iBoxx Liquid High Yield Index has yielded on average 6.24%, whereas the more popular Barclays Capital U.S. Aggregate Bond Index—which includes Treasuries, mortgage-backed bonds and investment-grade corporate bonds—has yielded 5.17% over the same period.
The iBoxx index during 2008 had a yield of 11.56%, whereas the Barclays Capital U.S. Aggregate gave investors a yield of 4.86%. Of course, iShares has another ETF (NYSE: AGG) that tracks the Barclays Capital U.S. Aggregate Bond Index, which has shown similar yield performance.
A Deeper, Broader Benchmark
The Markit iBoxx Liquid High Yield Index began implementing new rules and methodologies during the index’s June 30 rebalance. That process will continue over the next six months, leading to a gradual transition from the old index rules to the updated version. Besides more holdings, the new index will wind up with more diversity among sectors.
Barclays Global Investors, which runs the iShares family, has said that it will continue to use the index for their high-yield ETF, commenting that they intend to manage the fund to keep cost, tax consequences and turnover low.
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].