In recent weeks, I've written analyses on two popular corporate bond ETFs, the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD) and the iShares iBoxx $ High Yield Corporate Bond Fund (HYG). Since writing "LQD: Do You Know What's In Your Bond ETF?" and "HYG: Peeking Inside This High-Yield ETF," I've received questions about details on the SPDR Barclays Capital High Yield Bond ETF (JNK). I decided to take a closer look and here is what I found:
With an inception date of November 28, 2007, the JNK is a $9.7 billion fund that seeks to track the returns (before fees and expenses) of the Barclays Capital High Yield Very Liquid Index. This index includes corporate bonds rated Ba1/BB+ or lower by Moody's and S&P respectively, which also have the following characteristics: U.S. dollar denominated, pay taxable interest, have at least one year until maturity, and have at least $600 million of outstanding face value. Furthermore, the bonds must pay a fixed-rate of interest or provide a return according to a predetermined schedule (zero-coupon bonds, step-up coupons, etc.). Private placements are not included in the index. The index includes only three corporate sectors: Financials, Utilities, and Industrials.
Since the fund's inception through December 31, 2011, the JNK, based on its market value (trading at a premium to net asset value), returned 6.07% on a compound annualized basis. Based on its NAV, the JNK's compound annualized return is 5.76%, 31 basis points less than its market value return. Its benchmark index, however, has returned 9.20% on a compound annualized basis. This means that an investor in the JNK, using the market value return, has trailed the fund's benchmark index by 3.13% (313 basis points) per year. The gross expense ratio for the JNK is only 40 basis points, so this doesn't come even close to making up for the massive underperformance. Trailing the benchmark by roughly eight times the expense ratio on an annual basis is an enormous amount and should be a real eyebrow-raiser for anyone considering investing in this ETF.
A part of me feels as if I should stop the analysis right now given the huge underperformance of the JNK versus its benchmark. However, my curiosity and hope for a silver lining carries me on.
Recently trading at $38.96, the JNK has average volume over the past 90-days of approximately 5 million shares per day. As of January 20, 2012, the fund held 98.96% of its assets in bonds and 1.02% in cash. In terms of yield, JNK's 30-day SEC yield is 7.24%.
With regard to credit quality, this high yield corporate bond ETF holds most of its assets in bonds rated somewhere in the six B-rated categories of Moody's (MCO) and S&P. The Moody's ratings are Ba1, Ba2, Ba3, B1, B2, and B3; the S&P ratings referred to above are BB+, BB, BB-, B+, B, and B-. Approximately 85% of the JNK's assets are invested in securities with one of the aforementioned Moody's or S&P ratings.
In general, Ba ratings by Moody's represent obligations with "speculative elements and are subject to substantial credit risk." B ratings are considered "speculative and are subject to high credit risk." From S&P's perspective, BB issuers are "less vulnerable in the near-term but face major ongoing uncertainties to adverse business, financial and economic conditions." S&P's B ratings are for companies considered "more vulnerable to adverse business, financial and economic conditions but currently [have] the capacity to meet financial commitments."
The JNK also has 14.40% of its assets invested in C-rated paper. These are bonds of companies that are, at best, of "poor standing" and "subject to very high credit risk," from Moody's perspective. From S&P's point of view, C-rated paper is, at best, "currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments."
Nearly 80% of the fund's assets are invested in securities with five to ten years until maturity, and another 14.45% of assets are invested in securities with three to five years until maturity. Regarding the breakdown by sector, as you might expect from the aforementioned description of the Barclays Capital High Yield Very Liquid Index, the JNK appears to be incredibly non-diversified. As of January 20, 2012, according to the JNK's webpage, the fund is made up of Industrials (XLI), Utilities (XLU), Financials (XLF), and a small cash position. Industrials make up 84.84% of the fund, and Utilities and Financials make up 7.75% and 6.37% respectively. Perhaps we have found a silver lining in that the JNK only has a small allocation to financials. For those investors seeking mostly to avoid Financials, the JNK might appear attractive.
As you might have noticed above, I stated "according to the JNK's webpage" when mentioning the three sectors in which the ETF is invested. When looking through the individual holdings of the ETF, you immediately come across the largest holding: HCA Holdings (HCA), which has a weighting of 1.57%. This company, a healthcare service provider, managing more than 150 hospitals and 109 freestanding surgery centers, belongs to the Healthcare Sector, not the Industrials, Utilities, or Financials. So why isn't State Street Global Advisors, through its "Fund Sector Allocation" on the "Holdings" portion of the JNK webpage on the SPDRs website, telling investors about the allocation to the Health Care sector?
Furthermore, the fund seems to struggle with its ability to disclose sector allocations given its inclusion of Freescale Semiconductor (FSL), a company many would consider to be a part of the Information Technology sector. There are other examples of companies that one could argue do not fit under Industrials, Utilities, or Financials, such as AMC (AMCX), Hertz Global Holdings (HTZ), Burger King, Rite Aid (RAD), and Cablevision Systems (CVC), with weightings of 0.66%, 0.49%, 0.45%, 0.38%, and 0.23% respectively.
To summarize, it appears the JNK, and perhaps its benchmark index as well, uses a very broad definition of the Industrial sector (this may be true of the other two sectors as well). Normally, I would say that nearly 85% exposure to one sector not only represents more concentrated exposure than many fixed income investors may be looking for, but it is also noteworthy for holders of industrial stocks looking to diversify into fixed income. However, without going through each holding one-by-one and verifying the type of business each company operates, I'm not sure an investor can get an accurate depiction of the true sector diversity of the fund simply by relying on the information provided on spdrs.com.
In my experience, it is quite unusual for a non-sector-specific fund to use such a broad definition of one sector of the financial markets, thereby making it appear as if that sector has an incredibly high allocation within the fund. I would assume that unless a fund was known as a sector-specific fund, it would want to appear as diversified as possible.
When looking beyond the sector breakdown, an investor does find significant diversity in terms of the quantity of the underlying holdings of the JNK. With more than 217 different CUSIPs (identifier for a bond, similar to an equity symbol for a stock) across roughly 190 corporations, the top holding (CUSIP) in the fund being only 1.57% of net assets, and the top ten corporate bonds being only 11.84% of net assets, the fund is certainly not overly concentrated in its exposure to individual bonds or to any one company.
With that said, when comparing just the top ten holdings of the JNK to its benchmark index, you will notice a couple glaring differences that perhaps begin to explain some of the exceedingly large underperformance of the JNK relative to its benchmark. For instance, the benchmark index has CIT Group's (CIT) 5/2/2017 maturing, 7% coupon bond as its top holding with a 2.02% weighting. The JNK has the same bond at a 1.02% weighting, only its ninth largest holding. Another example is Ford Motor Credit (F), the tenth largest holding in the benchmark index, with a 1.06% weighting. This 8/2/2021 maturing, 5.875% coupon bond has only a 0.69% weighting in the JNK, ranking it 34th in the fund's holdings. Other noticeable differences include Sprint Nextel's (S) 11/15/2018 maturing, 9% coupon bond, with a 1.57% weighting in the index, versus a 1.46% weighting in the JNK, as well as the First Data Corp. 1/15/2021 maturing, 12.625% coupon bond with a 1.38% weighting in the index, versus a 1.28% weighting in the JNK.
On a closing note, for those investors who like to use options to create synthetic long positions, take caution when dealing with JNK options. As I noted in "Selling Puts: A Passive Investment Strategy For 2012," various JNK options have undergone adjustments to their strike prices. Investors looking to trade options on the JNK would be wise to contact their brokers or spend some time on the OCC's website looking through the various "infomemos" on the JNK to learn about the reasons for all the adjustments.