High Yield Bond ETFs in an increasing rate environment

Investors looking for income have had to search beyond conventional fixed income assets in the last decade, one defined by historically low-interest rates and corresponding low bond yields. But in today’s post-pandemic environment, the landscape has changed, painting a rather different picture. While treasury yields are rising in an unprecedented way, the Federal Reserve and Central Banks across the globe, race to increase their benchmark rates in an effort to curb red-hot inflation. The inverse relationship between interest rates and bond prices is leading to increasing income streams derived through fixed income strategies. To put things into context, in a rising interest rate environment bond prices tend to fall while coupon rates generally remain constant pushing bond yields higher. Conversely, the opposite also stands true. Whenever interest rates are falling, prices of existing bonds tend to rise; their coupon remains constant, and yields go down.

Needless to say, not all fixed income investments and strategies are the same, nor do they have the same risk and return profiles.

The fixed income universe

Instead of borrowing money from banks, businesses, governments, and municipalities issue bonds in order to fund their operations and capital expenditures. Bonds are debt securities exhibiting a broad array of characteristics being issued by distinct issuers, paying different coupons, and having differing maturities. They are frequently distinguished by their credit quality. 

Measuring credit quality

Credit ratings, in an investment context, are analogous to credit scores in that they represent creditworthiness, but they should not be confused with one another. On the one hand, credit scores are expressed in numbers for individuals and small businesses, whereas credit ratings are expressed as letter grades for businesses and governments. Investment grade and high yield bonds share certain characteristics with credit ratings key in distinguishing between them. Standard & Poor’s, Fitch, and Moody’s are three of the most dominant credit rating agencies, distinguishing between investment grade and high yield bonds by assigning a combination of upper and lower-case letters to identify a bond’s credit rating. These agencies draw the distinction by employing a set of different factors and criteria such as the possibility of default and loss severity. A generally accepted rule is that the lower the credit rating, the riskier a bond is and vice versa.

High yield bonds are sometimes referred to as ‘junk bonds’ due to their apparent lower quality. The higher probability of an issuer defaulting on its obligations can be attributed to numerous factors such as unstable revenue streams, lack of sufficient collateral, or liquidity issues. These are examples of the type of risk that could influence fixed income securities grading. As a result, and in order to attract investors, high yield bonds need to compensate for the uncertainty associated with their debt, hence paying higher coupon rates than their higher quality counterparts. Standard & Poor’s and Fitch classify bonds with ratings below BBB (BB, B, CCC, CC, C, and D) as high yield while Moody’s considers those with a rating below Baa (Ba, B, Caa, Ca, C, and D) to fall within the high yield category. 

On the other hand, ratings above BBB (BBB, A, AA, and AAA included) and Baa (Baa, Aaa, Aa, and A included) are labelled as investment grade bonds, with a lower risk of default on their obligations.  

The Rising Rate Environment  

During a recent news conference, Fed Chairman Jerome Powell was quoted as saying: “We want to see progress. Inflation can’t go down until it flattens out. If we don’t see progress that could cause us to react. Soon enough, we will be seeing some progress.”. This move translated into a three-quarters of a percentage point increase in the Fed’s benchmark interest rate to fight against the 40-year high inflation, the most aggressive interest rate hike since 1994. 

On the bright side, high yield bonds aren’t particularly sensitive to rising interest rates. On one hand, that’s because rising rates usually coincide with an expanding economy resulting in higher corporate profits and consumer spending. On the other hand, high yield bonds exhibit shorter duration rendering them less sensitive to interest rate moves, whereas duration measures a bond’s price sensitivity to changes in interest rates. Effectively, it is an interest rate risk measure, calculated as the weighted average of the time until the bond’s cash flows are received, and expressed in years. 

Among other things, lower interest rate sensitivity and yield advantage over investment grade bonds are factors favoring high yield bonds in a rising interest rate environment. 

High Yield Bond ETFs

The Federal Open Market Committee (FOMC) members have indicated additional rate increases ahead in an attempt to decelerate red-hot inflation moving at its fastest pace since the 1980s’. Moreover, the Fed and Central Banks across the globe are facing a fierce battle against inflation, and it is becoming increasingly clear that 2022 will be the year of rising interest rates. Industry pundits expect that high yield bonds, despite their lackluster performance in few instances, are likely to be well positioned to benefit from such an environment with high yield bond exchange-traded funds (ETFs) offering investors a highly liquid and accessible way to gain exposure. 

The iShares € High Yield Corp Bond UCITS ETF (IHYG)[1] and the Xtrackers II EUR High Yield Corporate Bond UCITS ETF (XHYG)[2] are among Europe’s largest high yield bond ETFs. Both ETFs invest in corporate debt rated BBB and below. These ETFs are suitable for investors looking into reducing their portfolio’s sensitivity to interest rates, as IHYG has an effective duration of 3.2 years while XHYG has a duration of 3.28 years. 

Both funds are geographically concentrated in Europe with a small percentage of assets held outside the continent. IHYG costs 30 basis points a year more than XHYG, charging a TER of 0.5% vs a TER of 0.2% for XHYG.

Trackinsight's Fixed Income ETF Screener identifies 92 High Yield Bond ETFs currently available to European investors with combined assets under management of USD$21 billion[3].

__

[1]  IHYG - Fund data as of July 13th, 2022.

[2] XHYG - Fund data as of May 31st, 2022.

[3]AUM and fund flow data as of July 08th, 2022.