There is an informative article by John Heinzl of the Globe and Mail on the Canadian exchange-traded funds (ETFs) tracking U.S. high-yield bonds. I’ve been wondering which would be the best choice and it appears the answer is the iShares U.S. High Yield Bond Index Fund (XHY) — whose index has an average yield to maturity of 9.3%.
It’s the choice of bond expert Hank Cunningham, a fixed-income strategist at Odlum Brown and author of In Your Best Interest: the Ultimate Guide to the Canadian Bond Market. He says it’s the most diversified, with twice (290) the number of bonds in the Claymore and BMO offerings. Diversification is important in the junk-bond realm to lessen the impact of insolvencies that may afflict some of the issuers.
Cunningham has been recommending high-yield bonds to his clients because they generally do well when the economy is recovering, as now appears to be the case. Defaults can be expected to decline and investors’ appetite for risk to rise, which leads to price gains for the bonds.
The Canadian high-yield bond ETFs are hedged to Canadian dollars. This hedging might appeal to investors parking money for the short to medium term. They don’t want to have to worry about currency fluctuations cutting into yield.
Might be better to own the U.S. high-yield ETFs directly
Nevertheless, the cost of holding currency-hedged ETFs are not always contained within their annual management expense ratios (0.6% for XHY). Tracking errors can be noteworthy as Canadian Capitalist has pointed out.
Thus, long-term investors might prefer to hold U.S. high-yield bond ETFs directly rather than through Canadian vehicles (assuming currency changes smooth out over the long run). Choices include:
Actually, even if you intend to hold for a period less than the long term, the U.S. ETFs might end up the better bet. The economic recovery that Cunningham expects to enhance the value of high-yield debt should also be supportive of the U.S. dollar.
In other words, an economic recovery in the U.S. could put a lid on appreciation in the loonie against the U.S. dollar; it may even put downward pressures on it. So, currency fluctuations could be neutral or even positive for investors holding U.S. high-yield bond ETFs in 2010 and into 2011.
A drawback to buying U.S. ETFs is the currency fees Canadian brokers charge clients to buy and sell securities denominated in U.S. dollars. For the long-term investor, these costs are deemed insignificant; but for investors with shorter horizons, life might be simpler if they stay with the Canadian currency hedged ETFs.