HYG: Peeking Inside This High-Yield ETF

Jan.10.12 | About: iShares iBoxx (HYG)

How would you like to invest in a diversified $11.3 billion high-yield bond ETF with an average maturity of only 5.18 years and a 30-day SEC yield of 7.39%? It has ample liquidity and a lower allocation than the S&P 500 has to the sector that many investors want to shy away from nowadays: financials. The fund boasts investments in several well-recognized companies, including the American auto manufacturer Ford (NYSE:F); natural gas behemoth Chesapeake Energy (NYSE:CHK); the 125-year old time-tested retailer Sears (NASDAQ:SHLD); an iconic American brand in U.S. Steel (NYSE:X); “the home of the Whopper,” Burger King; and the company with that jingle that no child could forget, “I don’t want to grow up, I’m a Toys ‘R’ Us kid.”

On the other hand, perhaps you would be interested in a junk bond ETF, which between July 22 and October 4 of 2011 sold off more than 15%. It sports an annual expense ratio of 0.50% and has some exposure to bonds with more than 10 years to maturity. Based on Moody’s ratings, nearly two-thirds of the fund’s investments are four notches or more into junk territory, including more than 14% of its holdings in the substantially risky C-rated territory.

Among other companies, one company this ETF is invested in is CIT Group (NYSE:CIT), the commercial lender that filed for bankruptcy in 2009 after taking $2.3 billion in bailout money from American taxpayers. The fund also invests in Eastman Kodak (EK), rumored to be on the verge of bankruptcy, as well as Ally Financial, the former GMAC Financial (once the lending arm of General Motors), a company which is majority-owned by the U.S. Government after being bailed out multiple times over the past few years.

So which of these two descriptions is the more sound choice? This seems like an easy choice. Or is it? Actually, both of the descriptions are of the exact same fund: The iShares iBoxx $ High Yield Corporate Bond Fund, better known by its ticker symbol, HYG.

HYG is an ETF with underlying holdings in non-investment grade corporate bonds. For some investors, it may be tempting to simply buy the ETF because of its 7.39% yield and the belief that a well-diversified fund, even if it invests in junk bonds, will better shield you from counterparty risk. However, one of the many lessons from the crisis of 2008/2009 was that in a system in which very large numbers of investors attempt to diversify in the same way, people end up not as diversified as they think.

Even if you are a buy-and-hold investor, it pays to know what you are invested in. Don’t just buy an ETF or any other fund simply because of its name, its yield, or because it is invested in the names of companies you recognize. Spend a little time discovering exactly what it is you are interested in buying and find those wolves in sheep’s clothing before they find their way into your portfolio. With this in mind, let’s take a brief look at the iShares iBoxx $ High Yield Corporate Bond Fund.

With an inception date of April 4, 2007, HYG has been around for nearly five years. It attempts to track the performance of the iBoxx $ Liquid High Yield Index. Since the fund’s inception, HYG has returned 29.35% (including distributions), whereas the index returned 32.38%. When factoring in HYG’s expense ratio of 0.50% to the equation, the 3.03% underperformance since inception doesn’t appear as bad. All-in-all, HYG does a good job tracking its benchmark. If you would like to view a chart highlighting the tracking error of HYG, please visit the fund’s webpage on iShares.com.

Recently trading at $89.00, HYG has average volume over the past 90-days of approximately 2.367 million shares per day. As of January 4, the fund held 97.16% of its assets in bonds, 0.84% in cash, and 2% in a category marked “other.” In terms of yield, as of January 4, the fund’s 30-day SEC yield is 7.39%, and its trailing 12-month yield is 7.62%. According to iShares, the trailing 12-month yield is calculated by “summing any income distributions over the past twelve months and dividing by the sum of the most recent NAV [net asset value] and any capital gain distributions made over the past twelve months.”

In terms of credit quality, this high-yield (a.k.a. junk) bond fund holds most of its bonds rated somewhere in the six B-rated non-investment grade categories of S&P and Moody’s. The S&P ratings are BB+, BB, BB-, B+, B, and B-; Moody’s B-rated non-investment grade ratings are Ba1, Ba2, Ba3, B1, B2, and B3. Nearly 85% of the fund has one of the aforementioned S&P ratings, and just over 80% of the fund has one of the Moody’s ratings just referenced.

In general, BB/B (S&P) and Ba/B (Moody’s) ratings mean that the company is believed to currently have the capacity to meet its obligation on the bond, but that it faces major uncertainties, which could impair its future ability to meet its obligations. Depending on the credit rating agency, between 10% and 15% of the HYG's assets are in C-rated paper. This type of exposure is considered to be highly speculative and companies with these ratings are generally viewed as being currently vulnerable with respect to meeting their obligations.

Roughly three-quarters (75.3%) of the fund’s assets fall in the five to ten years to maturity category, and another 19.51% have one to five years until maturity. The remaining 2.35% of the fund’s assets held in bonds has ten to 15 years to maturity. In terms of the breakdown by sector, there is a good deal of diversity. Consumer Services represents 14.37% of the fund, and Financials, Telecommunications, Oil & Gas, and Technology round out the top five with 12.59%, 11.14%, 10.58%, and 10.19% respectively. The fund also has exposure to the Health Care, Industrials, Utilities, Basic Materials, and Consumer Goods sectors.

There is also significant diversity in terms of the quantity of the underlying holdings of the fund. With over 450 different CUSIPs (identifier for a bond; similar to an equity symbol for a stock) across roughly 200 corporations, the top holding CUSIP in the fund at only 0.84% of net assets, and the top ten corporate bonds only 6.71% of net assets, the fund is certainly not concentrated in its exposure to individual bonds. However, in terms of its risk to any one company, it is possible to find a relatively small percentage of the roughly 200 corporations making up a decent size of total net assets. Here are some examples:



% Of Net Assets

CIT Group (CIT)



HCA Holdings, Inc. (NYSE:HCA)



Ford Motor Credit (F)



Reynolds Group



First Data Corp.



Ally Financial






Sprint Nextel (NYSE:S)



Chesapeake Energy (CHK)



Valeant Pharmaceuticals Int'l (NYSE:VRX)





Click to enlarge

As you can see from the table, the bonds/notes of just ten companies, representing less than 5% of the total number of companies in HYG, make up 20.29% of net assets. That’s much more concentrated counterparty risk than an investor might have realized had he or she only looked at the number of individual holdings (by CUSIP) in the fund.

On a closing note, as of January 4, 2012, of the more than 450 different CUSIPs in HYG, only 123 had a market price under par (100 cents on the dollar). Of the 123 CUSIPs trading under par, only 33 were trading under 90 cents on the dollar. The lowest market price on the list belonged to Petroplus Finance Limited (0.06% of net assets), maturing May 1, 2017, and trading at 49.06 cents on the dollar. The highest market price in the HYG belonged to a Ford Motor Credit note (0.24% of net assets), maturing May 15, 2015, and trading at 122.67 cents on the dollar.

Disclosure: I am long two X CUSIPs.