High yield ETFs versus high yield bond funds and volatility: the case of the hare and the tortoise?
When it comes to choosing bond ETFs over bond funds, investors have traditionally chosen ETFs for some obvious reasons: higher liquidity, lower costs, shorting possibilities. And these reasons make sense overall. And this line of reasoning holds even truer if one were to compare high-yield bond ETFs versus high-yield bond funds. Take some typical examples. According to US News Money, one of the high-ranking high-yield ETFs is the iShares 0-5 Year High Yield Corporate Bond ETF (NYSEARCA:SHYG), with a 5.28% yield and 0.5% in fees. Or the one I will look at in this article, the SPDR Barclays Capital Short Term High Yield Bond ETF (SJNK) with a 5.99% yield, 0.4% in fees, but with a recent YTD return of -1.05%.
Besides the concerns investors have about fees, returns, and the average duration of the holdings, recently another big issue has reared its head-namely how the ETFs react to overall volatility in the market (both the corporate bond market and even to some extent volatility in Treasuries).
Volatility shifts in the high-risk corporate bond market and the 1-year Treasury market.
These two markets have been behaving strangely over the past two years. The following two graphs show the trends. While the spread between Baa corporate bond yields and 1-year Treasuries have remained pretty steady over the past two years (declining recently a bit), the volatilities in these markets have been all over the place. (I used the 1-year Treasury as a benchmark because both of the high-yields I look at below are on the short end.) In particular, the monthly standard deviations were pretty high for the corporate high-risk sector towards the end of 2014, increased again, and then have declined lately, probably because there were recent hopes of a decline in the unemployment rate. On the other end of the spectrum, 1-year Treasuries have been pretty smooth until a recent uptick in their volatilities.
Source: Federal Reserve Bank of St. Louis
So the question is, should one choose a high-yield bond fund over a high-yield ETF when volatilities are down in the underlying corporate bond market? To answer the question, I compare the way the above-mentioned Barclay's ETF compares to a bond fund with approximately the same asset value, namely the Wells Fargo Short-Term High Yield Bond Fund (MUTF:SSTHX). (Its yield is 2.97%). SSTHX has approximately the same asset position as SJNK ($1.3 billion for SSTHX compared to $2.5 billion for SJNK). More to the point the durations of the holdings are somewhat equivalent (2.39 years for SJNK versus 1.26 years for SSTHX). The investors in these two funds, being as they are on the short-end, shouldn't have too many volatility worries, a priori. That doesn't seem to be the case, since these two high-yields have quite different reactions to changes in the volatility structure of the underlying bond markets.
High-yield ETF follows its own music while the bond fund more correlated with Treasuries.
Since the SSTHX fund is an open-ended fund, its prices should be following NAVs daily (or pretty much close to it). One measure of the volatility in the fund would be the difference between the daily NAV and the average NAV over the period (a quick measure of the extent of redemptions or issuances). On the other hand, the volatility of the ETF can be measured in the standard way. The following graphs show the relative movements of the volatilities of these two high-yields compared to the Baa yield and 1-year Treasury. The volatility of SJNK doesn't seem to be following the volatilities of either of the underlying markets. On the other hand, the SSTHX fund seems relatively stable, but even there one sees a peak in the volatility towards the end of 2015. The table that follows provides the correlation between the two high-yields and the 1-year Treasuries and Baa yields over the past two years .
Source: finance.yahoo and Federal Reserve Bank of St.Louis
Treasury 1-year rate and SJNK
Treasury 1-year rate and SSTHX
Baa corporate yield and SJNK
Baa corporate yield and SSTHX
Correlations between 2014-2016
Source: Federal Reserve Bank of St.Louis and finance.yahoo.
So is the bond fund tortoise better than the bond ETF hare?
All of the above may seem pretty technical. But here's one or two takeaways. Bond fund ETFs are pretty popular because of the low fees, despite the absence of active management. High-yield bond ETFs would seem to provide the best of all possible worlds - relatively low fees with attractive yields. Yet, one should be wary about the volatility of these ETFs, and more to the point, how these ETFs correlate with the underlying holdings. A short-run high-yield ETF like SJNK might seem to have little volatility concerns, being on the short end. However, it seems to not provide a very high correlation with underlying Treasuries (probably because of the lack of active management) and low correlation with the corporate bond yield. The slow and steady bond fund tracks Treasuries pretty well, has shown to have a relatively low level of redemptions or issuances. But of course, the yield is considerably lower.
Disclosure: I/we 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.