However, investors in high yield bonds also face high index turnover, elevated trading costs, and restricted market liquidity.
Another issue for high yield investors is a sustainability challenge, as high yield bonds are more than twice as pollutive as their investment grade counterparts, and almost three times more pollutive than equities in terms of their carbon footprint.
Despite this, it is possible to develop a high yield solution that addresses these issues and aims for market-like risk and return with improved sustainability.
Passively investing in the high yield corporate bond market is a daunting task. High yield indices are diverse, and their composition varies over time; they offer limited liquidity, while transaction costs in this market are relatively high. This means there is no simple way to generate market-like returns in high yield.
Full replication of the global index through buying and holding the 3,000 index constituents is practically impossible: there simply is no daily liquidity in all of the constituent bonds. Turnover is also high as hundreds of bonds drop out of the index every year as they mature, are called, default, or migrate to investment grade.
An assessment of the relative return of six large, anonymised ETF US high yield index products versus their benchmark index for example, shows four of the six ETFs have underperformed their respective indices over the past 12 months. Four of the five ETFs with at least a three-year track record have underperformed over the past three years. Likewise, all three ETFs with a five-year track record underperformed over the past five years.
An additional drawback of passive high yield is, by definition, that it does not take sustainability considerations into account. A passive investor simply aims to buy all firms in the index, without considering their ESG risk, carbon footprint or other sustainability dimensions.
As the share of companies in the energy, utilities, and metals and mining sectors is much larger in a high yield index than in an equity index, high yield can be regarded as a pollutive asset class, on average. For example, the weighted average carbon footprint of all companies in the global high yield bond index is roughly three times higher than that of the MSCI World equity index. The number of companies exposed to severe ESG risk is more than five times higher in high yield than in equities.
Investors would be well-served in looking for a systematic, research-driven investment process when assessing high yield strategies, and should consider the following points:
1. Determining the credit universe
The Bloomberg Global High Yield Corporates index serves as the starting point for determining the investable universe.
2. Matching index exposures
In order to generate market-like returns, a portfolio should be constructed to have similar exposures to key market risk dimensions like sectors, ratings, and currencies. Controlling these key risk dimensions reduces the tracking error of the portfolio with respect to the selected index while allowing the portfolio to hold significantly fewer bonds than the market index.
3. Improving sustainability
Set the portfolio’s desired sustainability profile. The sustainability profile can be measured relative to the index, in absolute terms, or can be formulated in terms of exclusions.
4. Selection of individual bonds
Bonds can be ranked from highest to lowest expected return by using a credit selection model. By investing more weight in high-ranked bonds and less weight in low-ranked bonds, this strategy is expected to be able to offset the trading costs incurred in the strategy.
5. Human oversight
Portfolio managers and fundamental credit analysts also have an important role. They may overrule the model’s individual bond selection if risks are identified that are not accounted for in the data, for example, material ESG or climate risks.
6. Portfolio construction
The portfolio construction process systematically considers the availability of bonds to allow for cost-effective implementation.
The result of this methodical investment process is a well-diversified portfolio that has a similar risk and return profile as the index, with improved sustainability.
Patrick Houweling, portfolio manager, Robeco
