This Fixed-Income ETF Has Its Trade-Offs

| About: PowerShares Fundamental (PHB)

By Alex Bryan

Traditional market-capitalization-weighted bond indexes get a lot of flak for assigning the largest weights to the most-heavily-indebted issuers. For instance, it may not be optimal for investors to hold more General Motors (NYSE:GM) debt just because GM needs to raise more money. Market-cap-weighted equity indexes share this potential drawback. Companies that issue stock can increase their market capitalizations without any changes in the fundamentals of the business, simply by raising more cash through the sale of additional shares to the public. However, this issue is likely less pronounced for stock than bond indexes because most companies rely more heavily on debt financing. Skewing toward the most-indebted issuers may be particularly problematic in the high-yield bond market because these issuers may carry greater default risk than their less indebted counterparts. The biggest debtors may also be more likely to suffer a credit-rating downgrade, which could hurt performance.

PowerShares Fundamental High Yield Corporate Bond (NYSEARCA:PHB) attempts to address this issue by weighting its holdings according to fundamental measures of their issuers' size, including sales, cash flow, dividends, and the book value of their assets. This approach may give the fund less exposure to heavily indebted companies than its peers that weight their holdings by the market value of each issue. But where market-cap weighting offers the advantage of tilting a portfolio toward the most-liquid bonds, this fund may overweight some of the less liquid issues. These bonds can be more difficult to obtain and more expensive to trade. In order to limit this potential problem, the fund's benchmark, the RAFI Bonds US High Yield 1-10 Index, restricts its holdings to issues with at least $350 million in par value outstanding.

Yet this benchmark may still be more difficult to replicate than a market-cap-weighted index. Over the trailing three years through March 2014, PHB lagged its benchmark by 1.26% annualized, considerably more than its 0.50% expense ratio. This underperformance does not inspire confidence, and if it continues, it could erode the index's potential performance edge relative to a market-cap-weighted alternative.

Although the fund's fundamental weighting approach may reduce its exposure to the most-indebted companies, nearly all high-yield bonds are issued by companies with a high degree of leverage. Companies can get there either intentionally by way of a debt-financed acquisition or recapitalization, or unintentionally as a result deteriorating business fundamentals. Either way, the risk posed by leverage is the same. As leverage increases, so does the probability of default and bankruptcy. The high yield that these bonds offer is compensation for this risk.

In contrast to some of its index peers, PHB excludes bonds that either Moody's or S&P rate below B3/B-. This exclusion may help improve the fund's risk-adjusted performance. Investors reaching for yield may be tempted to tilt toward the lowest-grade bonds and, in their quest for income, push the prices of these bonds above their fair values. During the past 10 years, the Bank of America Merrill Lynch US High Yield CCC or Below Index generated lower risk-adjusted returns than the corresponding BB and B indexes. The CCC index's option-adjusted spread (yield adjusted for embedded options, minus the yield on duration-matched Treasuries) is currently the lowest it has been since 2007. This means that the incremental reward for bearing this credit risk is lower now than it has been during the past few years.

During the past 10 years, BB rated bonds offered better risk-adjusted returns than their investment-grade and lower-credit-quality counterparts. Most investment-grade funds cannot hold BB rated securities, which can create forced selling when investment-grade issues are downgraded to BB. These issues may also be less attractive to investors reaching for yield than their lower-quality counterparts. As a result, they may become undervalued relative to other bonds. BB/Ba bonds account for close to 60% of PHB's assets, which may give it a more favorable risk/reward profile than many of its peers, even if it offers a slightly lower yield.

As of this writing, PHB carries a 4.4% yield to maturity. While this yield may appear attractive relative to investment-grade alternatives, high-yield bonds' spread over Treasuries is currently fairly low. As of June 20, 2014, the option-adjusted spread on the Bank of America Merrill Lynch US High Yield Master II Index (a commonly cited high-yield bond benchmark) was about 3.4%. Since the end of 1996 (the earliest this data is available), the median spread was 5.3%. Credit spreads tend to widen during recessions and times of uncertainty, when issuers may have less capacity to service their debt. For instance, the spread on the high-yield index grew to more than 20% at the end of 2008 and jumped again toward the end of 2011 during the European sovereign debt crisis. However, credit spreads have been tightening during the past couple of years as economic conditions have improved.

This sensitivity to the business cycle causes high-yield bonds to behave more like equities than investment-grade bonds. The Bank of America Merrill Lynch US High Yield Master II Index was 0.74 correlated with the S&P 500 during the past decade. During that time, it was only 0.27 correlated with the Barclays U.S. Aggregate Bond Index.

A stable U.S. economy should help keep default rates low. According to S&P, the default rate on U.S. speculative-grade debt was 2.1% in 2013, which is below the 4.3% average dating back to 1981. However, most of these defaults tend to come from bonds rated CCC and below, which this fund does not own.

High-yield bonds tend to outperform investment-grade bonds during periods of rising interest rates, which usually occur as the economy strengthens, because the benefit of tightening credit spreads partially offsets the negative effect of rising rates. The fund's moderate duration (4.0 years) should also help mitigate losses when rates rise.

Portfolio Construction
PHB employs representative sampling to track the RAFI Bonds US High Yield 1-10 Index, which includes nonconvertible, fixed-coupon high-yield corporate bonds with up to 10 years until maturity. All issuers must be publicly traded companies. Each bond in the index must also have a par value of at least $350 million outstanding and carry either a Moody's or S&P rating of BB+/Ba1 or lower, but not below B3/B-. That means the fund may hold some bonds that one of the agencies has rated BBB/Baa, as long as the other assigned a BB+/Ba1 rating or lower (but above B3/B-). The index calculates the percentage weight of each issuers' sales, cash flow, dividends (where applicable), and book value of assets against the aggregate values of each of those metrics. To reduce turnover, the index uses five-year averages for each factor, except book value. The index averages those four values to assign each issuer's weight. For those companies that do not pay dividends, the average of the other three factors determines the issuer's fundamental weight. If the issuer has more than one qualifying bond, the index selects the largest issue with one to five years to maturity and the largest issue with five to 10 years to maturity. Therefore, there can be up to two bonds per issuer. In these cases, the index divides the issuer's weight equally between the two bonds. The index rebalances to the fundamental weights annually in March and makes other adjustments monthly.

SPDR Barclays High Yield Bond (NYSEARCA:JNK) (0.40% expense ratio) and iShares iBoxx $ High Yield Corporate Bond (NYSEARCA:HYG) (0.50%) offer similar exposure. In contrast to PHB, these funds apply market-cap weighting. They also include CCC rated bonds, which could make them a little risker. JNK currently offers a higher yield to maturity (5.7%), while HYG's 4.5% yield is comparable to PHB's.

Actively managed Fidelity High Income (SPHIX) (0.72% expense ratio) may be more appealing for investors who prefer to stay away from market-cap weighting and potentially benefit from fundamental research. It is currently the only high-yield bond U.S. open-end mutual fund that carries a Morningstar Analyst Rating of Gold.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

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