Seeking Alpha From This High-Yield ETF

| About: AdvisorShares Peritus (HYLD)

Over the years, I have spoken to many investors who are comfortable selecting individual stocks for their portfolios, but fear diversifying their fixed income allocation across individual bonds. For these investors, when it comes to bond investing, diversified funds have been the way to go. And they don't favor just any diversified fund, they often invest in passive funds with hundreds of holdings tracking a particular index.

Three popular examples of passive corporate bond funds are the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSEARCA:LQD), the iShares iBoxx $ High Yield Corporate Bond Fund (NYSEARCA:HYG), and the State Street Global Advisors SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK). At the moment, LQD has 1,019 holdings; HYG and JNK have 691 and 255, respectively.

If you are a money manager whose clients demand more of you than simply investing in passive index funds, but you are less confident in your ability to select the right mix of individual bonds, consider actively managed funds. Given the difficulty of finding yield in today's low interest rate environment and the intense focus investors seem to have on income, I would like to discuss a high-yield bond ETF that deserves to be on investors' radar screens: the AdvisorShares Peritus High Yield ETF (NYSEARCA:HYLD).

This high-yield bond ETF is actively managed and has two goals. The primary objective of the fund is to generate high current income, and the secondary goal is to capture capital appreciation. It currently has roughly $137 million of assets invested across 49 different bonds. As the following table illustrates, the maturities of those bonds range from 2013 to 2022:

Year of Maturity

Number of Bonds





















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Next, let's dig a bit deeper into the fund while keeping four things in mind that are important to pay attention to when allocating money to bonds: duration, diversification, yield, and credit quality.

1. In general, duration refers to a bond's (or bond portfolio's) price sensitivity to changes in interest rates. In other words, duration refers to how much the price of a bond is expected to move (up or down) for every 100 basis points move in interest rates. The duration of HYLD is currently 3.61 years. This compares to durations of 3.95 and 4.21 respectively for the aforementioned high-yield bond ETFs, HYG and JNK.

2. Building a diversified portfolio of individual bonds is especially important when venturing into the world of junk bonds. HYLD's portfolio holdings are currently diversified across 26 different industries. Given that it only holds 49 different bonds, I was quite impressed to see that type of diversification. Some examples of different industries to which HYLD has exposure include Airlines, Advertising, Auto Parts & Equipment, Beverages, Forest Products & Paper, Oil & Gas, Health Care - Services, Aerospace/Defense, Chemicals, and Transportation. Only two industries, Oil & Gas and Health Care - Services, have double-digit weightings in the fund, at 10% and 11% respectively.

3. In terms of yield, this is where HYLD has a distinct advantage over the two behemoths in the high-yield ETF world, HYG and JNK. At the moment, HYLD sports a 30-day SEC yield of 9.52%, whereas HYG checks in at 5.45% and JNK at 5.70%. Investors should be aware that HYLD's expense ratio, at 1.36%, is much higher than HYG's (0.50%) and JNK's (0.40%). That is the price you pay for active management. But even after accounting for the higher expense ratio, HYLD still has a yield advantage of roughly 4% against HYG and JNK. How is HYLD managing to generate such a high yield in today's ultra-low-interest-rate environment? That leads me to credit quality.

4. The bulk of HYLD's portfolio is concentrated in single B rated bonds. Using S&P's rating system as a guide, HYLD has 72.78% of the fund invested in bonds with B+, B, or B- ratings. More specifically, 27.84% hold a B+ rating, 31.16% hold a B rating, and 13.78% hold a B- rating. A little over 10% of the fund is held in double B rated bonds, and the remainder is either rated below single B or not rated.

In comparison, HYG has just 39.95% of its portfolio in single B rated bonds (using S&P's ratings scale) and 44.67% rated between BBB- and BB-. The much larger exposure to higher-rated bonds helps explain why HYG's yield is so much lower than HYLD's. Likewise, JNK also has much less exposure to single B rated bonds than HYLD, at 49.93% of the portfolio. JNK's double B exposure, at 35.08%, is more than triple HYLD's. Again, that helps explain JNK's lower yield.

But just because HYLD's portfolio generally has a heavier weighting to lower credit ratings does not mean it is necessarily of a lower credit quality than HYG's or JNK's. As it states in HYLD's prospectus, dated October 28, 2011:

"Peritus seeks to exploit the fact that most fixed income investors continue to use ratings as one of their primary investment tools. Peritus, however, believes that the focus should be on the fundamentals of the businesses in which the Fund invests rather than ratings. Peritus views credit as either 'AAA' or 'D' (i.e., it either pays or doesn't). Due to this investment ideology, Peritus places limited value on credit ratings and instead focuses on true cash flow while looking to buy credit at prices that it feels provide a margin of safety."

According to Moody's Investors Service's Annual Default Study: Corporate Default and Recovery Rates, 1920-2011, the average annual default rate among single B rated bonds from 1920 to 2011 was 3.423%. The highest default rate in any one year was 19.444% in 1970. In comparison, double B rated corporate bonds had an average annual default rate of 1.073% during the same time period. It is when you start buying below single B that the risk of default really spikes much higher; the average annual rate since 1920 jumps to 13.769%.

In other words, it is entirely possible for an actively managed ETF to create a diversified portfolio of several dozen individual bonds (rather than several hundred) heavily focused in the single B rated category without falling prey to defaults. And if you find such a fund, you will have a wonderful opportunity to outperform other assets not just from an income standpoint but also, if your timing is good, from a total return standpoint.

As many professional money managers will attest, timing matters. In the world of bonds, having the ability to be more aggressive with your purchases when spreads are wide, and scale back your purchases (and even sell holdings) when spreads have narrowed, is important. That will help you outperform over a period of many years. It is also one of the benefits of active management.

At the moment, spreads have narrowed significantly across the high-yield corporate bond universe since last year's sell-off. Using the "BofA Merrill Lynch US High Yield B Option-Adjusted Spread" as a guide, on a historical basis, today's single B corporate bond spread represents an average amount of value. The spread is still roughly 300 basis points above its 2007 low, but it is also a solid 450 basis points below levels I would expect it to reach during a recession.

If you think the economy is going to take off in the near future, then the current 536 basis points spread for single B corporates is something to be bought. If you think the economy will muddle through with slow growth, then today's spreads represent enough value to begin scaling into a position. If, however, you think a recession or pullback in "risk assets" is on the horizon, then better entry points await you in high yield bonds. Even though HYLD is an actively managed fund, investors should not expect it to be able to avoid a widespread sell-off if high-yield bonds. But investors can expect it to outperform during such times.

In October 2011, during the worst of the sell-off in "risk assets," the aforementioned single B spread reached 925 basis points over Treasuries. During the sell-off that culminated in that 925 basis points spread, high-yield bonds were getting hit across the board. From its July 22, 2011 high of $91.86 to its October 4, 2011 low of $77.90, HYG sold off 15.20%. Also, during that time, HYG had three ex-dividend dates for distributions worth a total of $1.65236. Without accounting for taxes paid on the distributions, the payouts would have lowered the sell-off to 13.64%.

From JNK's $40.46 high on July 22, 2011 to its $34.09 low on October 4, 2011, the fund pulled back 15.74%. Also, during that time, JNK had three ex-dividend dates for distributions worth a total of $0.73518. Without accounting for taxes paid on the distributions, the payouts would have lowered the sell-off to 14.18%.

Given HYLD's much larger exposure to bonds with lower credit ratings, investors might have expected HYLD to underperform during the July 22 to October 4, 2011 sell-off. That, however, did not happen. In fact, HYLD outperformed by quite a bit. From its $52.02 high on July 22, 2011 to its $45.12 low on October 4, 2011, HYLD declined by 13.26%. Remember that HYG and JNK each sold off more than 15% during that time period. When factoring in its three distributions totaling $0.87, the amount of the pullback is lowered to 11.79%. This means HYLD outperformed HYG and JNK by 185 basis points and 239 basis points respectively during last year's significant sell-off in so-called "risk assets."

For those investors intrigued by what they have read thus far about HYLD, here are three additional points to consider:

1. Keep an eye on whether the fund is trading at a premium or discount to its net asset value (NAV) before you make a purchase. Of the 198 trading days this year through October 12, HYLD traded at a premium of 0.25% or greater to its net asset value on 87 of those days (43.94% of the time). On the other hand, HYLD only traded at a discount of 0.25% or greater to its NAV on five occasions this year. When getting ready to purchase the fund, be sure to watch for those opportunities when the fund has both pulled back in price and is trading at a discount to NAV.

2. According to HYG's "2012 Prospectus," last revised July 10, 2012, the fund is designed to track an index that includes bonds only from issuers with at least $1 billion outstanding face value and bond issues that have at least $400 million outstanding face value. JNK's prospectus, dated October 31, 2011, indicates that the index it tracks requires corporate bonds to have at least $600 million of outstanding face value. HYLD, however, has no such limitation.

In its September 2012, "The Necessity of Active Management in High Yield Investing," Peritus Asset Management points out that only 28% of the Barclays High Yield Index has bond holdings of over $600 million (JNK requirement). Additionally, only 37% meet both the $400 million issue size and $1 billion issuer size requirements of HYG. In other words, HYLD has the ability to invest in corporate bonds that HYG and JNK will never consider. For the investor interested in diversifying across the high-yield corporate bond market, this alone is reason to at least consider an investment in HYLD.

3. One point of contention some investors may have with HYLD is that it trades very few shares on a daily basis. The 90-day average is just 27,844 shares versus 3.2 million shares for HYG and 4.57 million shares for JNK. Liquidity is certainly something every investor should concern themselves with. I find liquidity so important that I dedicated an entire chapter to it in my newly published book, "The 5 Fundamentals of Building a Retirement Portfolio." In that chapter, I point out that investors should not confuse volume with liquidity. They are not synonymous. As I mention in my book, investors should pay particular attention to market depth when gauging liquidity. With that said, investors buying and selling securities with very little volume should be mindful of bid-ask spreads. These are a form of transaction costs and tend to be wider in securities with lower daily volume.

On a closing note, I think it is even worthwhile for equity-oriented investors to take a hard look at HYLD. If you think the world will endure several more years of low interest rates and slow economic growth, then the more than 7% yield advantage HYLD has over the S&P 500 (NYSEARCA:SPY) makes it hard to ignore. After all, given the positive directional correlation of the high-yield corporate bond market with the S&P 500, the S&P 500 will have a lot of yearly outperforming to do from a capital appreciation standpoint to beat HYLD.

In an environment in which the high-yield market sells off, there is a strong likelihood that would be the same type of environment that would take stocks down with it. Not only has the S&P 500 declined by more than 50% in each of the last two bear markets, but during the sell-off in "risk assets" referenced earlier in this article (July 22, 2011 to October 4, 2011), the S&P 500 dropped by 20.16%. Even when accounting for SPY's one ex-dividend date during that time, the sell-off was still nearly 20%. Any way you slice it, that was a dramatic underperformance relative to HYLD.

Even though I do not yet own HYLD, it is going on my watch list of securities to buy on the next significant pullback in "risk assets."

Disclosure: I am long HYG. 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.