There has been a lot of pessimism lately about high-yield ETFs. Investors flocked to these funds once the Fed implemented its quantitative easing and zero-interest rate regime, in the hope that they could enjoy higher yields. Although they are also known pejoratively as 'junk bond' funds, due to the perceived lower quality of their bond holdings, many of these funds are actually safer investments than many stocks. In recent months, however, there have been rumblings about the possibility of the ETF bubble bursting.
Maximizing Investment Income
Under current market conditions, high-yield ETFs offer individual investors an invaluable opportunity to maximize interest revenue investment. In addition, institutional investors and mutual funds are also using the liquidity in ETFs to speculate on higher interest rates or hedge their positions in high yield debt. ETFs also hold tax advantages, as the capital gains tax charged on these funds is generally lower, because gains in for individual bonds are not realized until the asset is sold with the whole fund. Because of this, ETFs are considered tax friendly.
Of course, once the US economy recovers interest rates would start to go up again, making high-yield ETFs unattractive. But this will likely not happen in the short term since there are many fundamentals in the US that still need to be addressed. QE will not be removed until the Fed committee reaches its two remaining targets, an unemployment rate of less than 6.5% and an inflation outlook lower than 2.5 percent. Neither of these targets is likely to be hit soon and, in fact, the Fed recently signaled that an increase in quantitative easing may still be necessary. Until the Fed indicates that it is ready to starting easing on QE, these junk bond ETFs remains to bring decent returns. ETFs also provide you with flexibility in your investment decisions, since these funds can be traded as if they were equities. You can even sell these funds short or trade them on margin.
The biggest high yield ETF is the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG), with assets of over $16 billion. In April 2007, HYG tracks the performance of the iBoxx $ Liquid High Yield Index after it was launched. It is currently trading at $95.51. It enjoyed inflows of $4.2 billion in 2012 and $1.3 billion so far in 2013, indicating its popularity with investors. But is it time to dump the fund? Its fundamentals would indicate that it remains a solid investment, particularly in light of the fact that QE is not set to end any time soon.
A diversified investment portfolio
HYG's holdings include investments in such well-known companies as Toys R Us, natural gas company Chesapeake Energy, retailer Sears and MGM Resorts International. Although the fund is heavily weighted towards volatile sectors such as financials, oil and gas and consumer services issues, it has over 700 bonds in its portfolio, which are mainly US issues, helping to mitigate the default risk of its holdings. In addition, its holdings have an average weighted maturity of just over four years, and have a moderate investment risk.
Nearly half of the bonds in HYG have "B" ratings with a further 34% rated "BB" from S&P. These "B" ratings mean that the company is seen to have the capacity to pay its debts but faces major uncertainty which could hurt this ability in the future. A further 13% are ranked below B, which means that these companies are highly vulnerable and may not be able to meet their obligations.
High trading volume
On the average, some three million shares of HYG trade daily, and the fund has an expense ratio of 0.50, which means that you pay trading fees that are, on average, lower than what you would normally pay for the average high-yield fund. It is currently trading at $95.51 and has an average trading volume over the past ninety days of some three million shares daily, which makes the fund highly liquid.
The fund yields 6.5% while returning a capital appreciation of nearly five percent to its investors. HYG currently has a 12-month trailing yield of 6.36% and pays out dividends on a monthly basis.
Low tracking error
The HYG ETF's most recent tracking error was just .27 percent. Tracking error refers to how closely a fund tracks its underlying index. The lower the tracking error, the more preferable it is.
The Bottom Line
ETFs will continue to be an attractive investment instrument as long as the Fed continues to implement quantitative easing, which it seems set to do for the foreseeable future. Not only is HYG the biggest of the exchange traded funds, it also has a solid set of fundamentals as well as a solid earnings record. Hence, now is not the time for investors to divest themselves of their HYG holdings.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.