The Markit iBoxx USD Liquid High Yield Capped Index measures the performance of the most liquid US-dollar-denominated non-investment-grade corporate bonds issued by corporations located in developed economies. The bulk of issuance (80%-90%) is by nonfinancial corporations and tends to have medium-dated maturities. Around 90% of the index exposure is in bonds issued by US-domiciled corporations.
Eligible bonds must have a minimum outstanding of $400 million, a minimum maturity of 1.5 years, and a maximum of 15 years. The index is weighted by market capitalisation, subject to a 3% cap per constituent. The cap rises to 10% in the case of 144A bonds (that is, bonds not registered with the US SEC and sold only to qualified institutional buyers).
The index is calculated using consolidated prices derived from bid-ask quotes provided by contributing banks. The index is rebalanced monthly at the last business day of the month. Bonds with remaining maturity below one year at the time of rebalancing are removed from the index. Intramonth cash from coupons and partial redemptions are held as nonaccruing cash until the next rebalancing, when it is then reinvested in the index.
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The annual ongoing charge is 0.50%. This compares positively with the median clean share class fee for funds in its category (that is, inclusive of active funds). There are cheaper ETFs in the marketplace, although most lag substantially the iShares fund in AUM terms.
Additional costs potentially borne by investors and not included in the ongoing charge include bid-offer spreads and brokerage fees when buy/sell orders are placed for ETF shares. There are also rebalancing costs whenever the index changes composition.
The ETF has a decent tracking record. In the trailing three-year period, the ETF’s tracking difference (that is, the difference in returns between the fund and the index) came only slightly above its ongoing charge of 0.50%.
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IShares uses physical replication to track the performance of the Markit iBoxx USD Liquid High Yield Capped Bond Index. The ETF distributes dividends on a semiannual basis.
IShares uses stratified sampling to construct the fund. The index is broken down into sections, each representing key risk factors, such as duration, currency, country, rating, and sector. The managers then choose bonds included in the index that mimic the risk profile of each section. The aggregate result is a portfolio that represents the index's overall risk profile, while allowing the ETF manager to avoid purchasing bonds that suffer from illiquidity. As the ETF has grown in size, the extent of sampling has declined. According to our research, the ETF regularly holds a similar number of components as the index.
IShares engages in securities lending with the holdings of the ETF. BlackRock acts as investment manager on behalf of iShares. The ETF can lend out up to 100% of net asset value. However, historically, this ETF has lent out a marginal amount. The average on loan in the 12 months to the end of March 2019 was just 6.6% for an annualised return to the fund of 5 basis points. Lending operations are backed by taking UCITS-approved collateral greater than the loan value and by revaluing loans and collateral daily. The collateral is held in a ringfenced account by a third-party custodian. The degree of overcollateralisation is a function of the assets provided as collateral but typically ranges from 102.5% to 112.0%. Lending revenue is split 62.5/37.5 between the ETF and BlackRock, respectively.
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IShares USD High Yield Corporate Bond ETF is a useful instrument to for investors to quickly lock in positions in the market. However, this remains an asset class where experienced active managers have shown that they can add value over a standard index-tracking mandate. For this reason, the fund retains a Morningstar Analyst of Neutral.
The ETF tracks an index that provides broad exposure to the most liquid part of the underlying market, while not exposing investors the riskiest corners. This facilitates replication for passive fund managers while reducing risk, but it effectively narrows the investable universe, thus leaving out pockets of value that active managers can exploit.
Measured in the context of its Morningstar Category, which includes both passive and active funds, the ETF has delivered risk-adjusted returns slightly above the category average over the trailing three- and five-year periods. The ETF’s cost advantage relative to active funds has been a key explanatory factor.
However, the value of research and the flexibility of unconstrained mandates in high-yield bonds can give experienced high-yield bond active managers an edge on performance over the long term. Besides, active managers may be better suited to navigate the inherent high volatility of the high-yield bond market over a full market cycle.
IShares is a dominant force in the European ETF marketplace, and this market-leading ETF is a clear example of the strength of the brand and the overall robustness of the fund management process. We have a positive assessment of the portfolio management team in charge of passive funds at iShares.
Ultimately, while valuing the low cost of the investment proposition that this ETF represents, an index-tracking approach to this asset class comes with shortcomings in terms of providing an adequate representation of the available opportunity set. For this reason, the fund retains a Neutral rating.
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Investors’ interest for high-yield bonds rocketed since the global financial crisis of 2008 and remained firm for much of the postcrisis period. The market has found a new lease on life in early 2019, with investors encouraged by the Fed’s more cautious messaging about the path of interest rates. Further upside to US interest rates is now more in doubt. However, the economy remains resilient.
According to data from the Securities Industry and Financial Markets Association, annual high-yield bond issuance in the United States in the period 2013-18 averaged USD 248 billion. In the first four months of 2019, issuance totalled USD 82 billion. By means of comparison, in the precrisis years, the average annual issuance was around USD 100 billion.
High-yield bonds are somewhat atypical in the wider context of fixed income given their stocklike risk/reward nature. This means that higher interest rates do not necessarily weigh on performance in the same manner as for sovereign debt, at least in the initial phases of the tightening cycle. However, a sustained period of rising rates is unlikely to do favours to high-yield issuers, as they would likely find it increasingly taxing to issue and/or refinance debt. Also, higher interest rates typically increase the chances of higher default rates for high-yield bond issuers, which can spark episodes of volatility that experienced active managers may be better able to navigate.
For example, worsening fundamentals for energy sector corporations--mainly in the fracking industry--as a result of the collapse of oil prices in 2014-15 severely weighed on valuations. Standard market-cap-weighted US high-yield bond market indexes were highly exposed to energy sector issuers at the time, and so they captured the full downside.
High volatility is part and parcel of the high-yield bond market. This remains an area where the value of research and the flexibility of unconstrained mandates can give experienced active managers an edge on performance.
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As of this review, the two ETFs in the European marketplace offering comparable exposure are Lyxor BoFAML USD High Yield Bond and Xtrackers USD High Yield Corporate Bond. Both come with lower ongoing charges (0.30% and 0.35%, respectively). The Lyxor fund follows synthetic replication, while Xtrackers is physical.
There are other alternatives in ETF space, but investors would have to compromise in terms of maturity exposure or contemplate a global, rather than US-centric, approach to investing in the asset class. US exposure usually accounts for around 70%-80% of a global high-yield bond index basket.
PIMCO (Invesco), iShares, SPDR, and Lyxor offer ETFs focusing on the short-dated (zero to five years) maturity segment of the US high-yield bond market.
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