European high-yield investors should steer clear of ETFs

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Gershon Distenfeld is director high-yield at AB discusses high-yield ETFs issues.

Global high-yield markets can offer enticing opportunities for Europe’s income-starved investors. But accessing these markets using exchange traded funds (ETFs) exposes investors to numerous risks—and potentially disappointing rewards.

Seeking broader bond horizons?
Many European investors are struggling to secure decent levels of income from their bond investments as European Central Bank (ECB) policy drives regional bond yields relentlessly lower.

Around 50% of Europe’s sovereign bonds yield less than zero. And now that ECB bond-buying has spread into the corporate bond market, the sub-zero interest-rate trend has taken root there as well. Around 15% of Europe’s investment-grade corporate bonds currently sport negative yields and about two-thirds yield between 0% and 1%.

Given this backdrop, it’s hardly surprising that growing numbers of European income-seekers are venturing beyond local bond markets in search of more enticing yields—as well as potentially valuable diversification benefits.

Global high-yield bond markets certainly offer attractive opportunities to invest in higher-yielding bonds, particularly since overall default levels are expected to remain low.

But passive investment strategies that simply track global high-yield indices—like ETFs— can leave investors overexposed to the riskiest opportunities—and underexposed to the most rewarding.

The problem with ETFs
Bond indexes provide useful historical snapshots of fixed-income markets. But they have limitations as benchmarks for investment strategies. Since issuing more debt increases a company’s weight in bond indexes, anyone buying an ETF ends up with greatest exposure to the companies that borrow most. This isn’t a prudent approach.

For example, by mid-2014, energy bonds had become the biggest single sector in the US high-yield index—itself the largest of the high-yield indexes—ensuring that ETF investors had more exposure to energy bonds than to any other sector. When energy companies started to come under intense pressure as oil prices began to decline, ETF investors were hit especially hard.

At least one asset manager recently launched an ETF that invests in every high-yield sector except energy. The idea was to limit the risk of losses and default associated with lower oil prices, which could make it hard for oil and gas companies to service their debt.

But running away from the entire energy sector today is akin to shutting the stable door after the horse has bolted. And it won’t necessarily leave investors well-placed to cope with whatever’s round the next corner.

The limitations of looking backwards were evident in the months after the global financial crisis. At the time, many investors decided to shun all bank bonds. This meant they missed out on a sharp rally as the financials sector rebounded.

Likewise, had an ex-energy high-yield ETF existed at the start of this year, investors who bought it might be kicking themselves today. Why? Because oil prices—and many high-yield energy bonds—have rallied over the last few months.

Selectivity at the sector level is only part of the story. We see wide differences in the attractiveness of individual bonds across the sector spectrum.

Unlike ETFs, active high-yield strategies can pick and choose which bonds to buy. This opens up scope to focus on issuers with strong fundamentals and solid credit metrics—and to steer clear of bonds whose downside risks could outweigh the potential gains.

The numbers tell the story
The potential rewards of a highly selective approach to global high-yield investing are evident when we turn to the numbers. It’s now more than eight years since the inception of the world’s largest high-yield ETFs.

Over this period, they’ve consistently underperformed actively managed high-yield mutual funds.

We think there’s value to be found in the global high-yield market today—particularly given the scarcity of yield. But investors need to look for companies they believe can offer returns commensurate with their risk profiles, rather than just investing in an index based on companies with the biggest debt burdens.

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