High-Yield Bond ETF: Take On Risk for Better Returns

I've written in the past about bond ETFs and how they represent a portion, albeit small, of my portfolio. Up to this point I've only dipped my toes in to exchange traded funds that track the Lehman Aggregate Bond Index (AGG) and the iBoxx Corporate Bond Index (LQD).

Recently, Barclays launched a high-yield bond ETF that tracks the iBoxx Liquid High Yield Index (HYG). Of course, a higher yield means more risk, but this new offering does help round out the collection of ETFs from Barclays by focusing on lower-rate bonds that both AGG and LQD won't touch.

High-yield bonds currently pay out about 2.5% more than treasuries. Although the yield promises to remain relatively high, there will also be significant volatility. Another statistic of interest is that over the past 5 years, according to J.D. Steinhilber, "high yield bonds have delivered 10% annualized returns over this period with volatility of only about 60% of the S&P 500." Going forward, the general rule of thumb is that bonds will appreciate sharply during good economic times when there is little chance of default. However, when markets decline, credit spreads can widen and high yield can bear the brunt of the downturn.

It's been a while since I've bought in to a new ETF, but I think this one will change that. My biggest concern is that the management fee is quite high at 0.5% especially compared to bond ETFs from Vanguard that have fees that are 50% lower. Still, I like to cover various areas of the market and now I have a tool that gives me exposure to the missing piece in the domestic bond market. The one area missing still is an ETF or collection of ETFs that provide exposure to the international bond market.

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2 Comments

  1. Looking at the bond market today (November 18, 2008), a rebalancing for quality appears to be a great idea, perhaps worth one percent?

  2. Good information. It is a great investment tool having the ability to invest in the high yield sector in a diversified basis. The iBoxx Liquid High Yield Index has around 50 components. However, in addition to management fee of 0.5%, the way in which the index rebalances may be inefficient. I did a quick research on the i-shares site and on the index web site, at http://www.markit.com/en/products/data/indices/indices.page. Both have very good data and easily accessible. The iBoxx Liquid High Yield Index, as described in the rules brochure, rebalances every month so that it has the top 50 bonds in the high yield sector, based on certain rules and criteria, which summarized point towards having in the index the most liquid bonds in the sector. There is a factor for age, so that as time passes older bonds reduce their ranking. There is also a factor for bonds that are already in the index, so as to prevent to much changes in the constituents. To test how the rule actually worked, I downloaded data on the constituents of the index on a quarterly basis for the year ended June 30, 2008. I found that rebalancing may add up to 1.0% cost when replicating the index. That would make a pretax hit of 1.5% when adding trading costs with management fee. Not a good figure to take the full potential our of the HYG idea.

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