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    High Yield Corporate Bond ETFs Can be a Risk-Return Game

    At a time when bankruptcy levels are looking to reach the 2009 level, the high-yield bond market seems to be picking up steam. The initial days of the pandemic saw investors withdraw money from this segment but after the intervention by the Fed, we see fresh inflows backed up by investor confidence.

    The current economic scenario has also translated into more companies being pushed below the investment-grade category. The outlook was not so bad at the beginning of the year but the pandemic has led to many corporates with BBB rating fall to the high-yield category.

    Alex Richter, finance and asset management expert consulted our redaction that “While it is a cause for concern, investors could see the brighter side of it. Before 2020, the credit spread for this segment had tightened. Even after receiving significant inflows, the yield offered by this asset class continues to be high at a time when the interest rate is low.” he added that “Investors continue to be skeptical of the economic recovery and additional yield is required to compensate them. Many of the companies that were downgraded can possibly retain the BBB status once their business is up and running.”

    Even the valuations in the equity market seem stretched. ETFs focussing on the high-yield corporate bond market can be a worthwhile investment given the lack of options. ETFs offer diversification benefits that investors would not achieve if they invested in a high yield bond of a specific user. There are numerous ETFs and monitoring the holdings of these funds can be challenging for a retail investor.

    Features of These ETFs

    We analyzed some of the ETFs that focus on USD denominated high-yield corporate bonds.

    We see that the top 10 holdings in each of these funds account for less than 10%. These funds tend to be highly diversified in terms of issuers as well as industry. The number of holdings also tends to be large, unlike a traditional equity ETF where the count rarely crosses 100. From the perspective of an individual investor, it can be overwhelming to keep track of a large number of fixed income instruments.

    One would have also observed the high dividend yield of these funds. This is on account of the high coupon rates that the underlying positions provide. It needs to be highlighted that these ETFs have been able to sustain their historical level of dividends even during the pandemic without missing out on the monthly disbursals. It does make sense why these funds are invested in such a large number of holdings. Default on any one of these instruments has almost no bearing in the overall performance of the fund. 

    The 4-year average yield is almost the same across these funds and offers a good return to investors. There is a possibility that the yields may reduce once the economy is up and running and therefore, it is advisable to take advantage of this opportunity as early as possible. It is often seen that the credit spreads are minimal when the economy is performing well.

    The average maturity of the ETFs is within the medium term range and the duration of these funds should be lesser by approximately 1 year. This should provide some comfort to those investors who are not comfortable investing in long tenor bonds on account of interest rate risk. Investors should also be comfortable on this front since the yields are high and the impact of small changes in interest rate would not impact the portfolio significantly.

    The Flip Side

    While we have highlighted the benefits of diversification, the impact of a slowdown can be widespread thereby affecting almost every company issuing such bonds. The possibility of a hike in rate cannot be ignored in the future since the current interest rate is at a historically low level. Dividend payout may be impacted If companies default on account of a recessionary environment.

    Investing in high-yield instruments requires a  considerable amount of risk appetite that investors should be aware of. It is highly recommended to seek advice from experts because tracking so many funds can be intimidating. The high-yield market may be under some pressure as long as the pandemic looms but the potential that this sector presents should not be ignored.

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    The views and opinions expressed in this article are those of the author. They do not purport to reflect the opinions or views of the Fortune or its members.

     

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