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Ford Motor recently raised $8bn of high yield debt, much more the $3bn it was targeting, signalling increased investor demand for corporate bonds

In the middle of March when the world suddenly became aware of the economic consequences of the virus pandemic, the high yield or junk bond market almost became dysfunctional, according to Invesco fund manager Rhys Davies. Trading became very difficult as volumes shrank and prices fell (causing yields to rise).

Junk bonds are debts issued by companies that have poor fundamentals and weak balance sheets, and consequently have a higher chance of defaulting on their interest payments and going bust.

In just a couple of weeks the yield on junk bonds almost doubled, rising from 3.4% to 6.2%. Back in October when Shares last wrote about junk bonds, their yield was an incredibly low at 2.8%.

Examples of corporate and government bond ETFs

Invesco GBP Corporate Bond ESG UCITS ETF (IGBE)

Yield to maturity: 2.1%

This tracks an index of high quality debt issued by financially strong and stable companies. The index has an ESG (environmental, social and governance) filter which excludes companies involved in tobacco, weapons, thermal coal or oil sands. The weights of the index constituents are then adjusted based on certain ESG metrics, with the aim of increasing overall exposure to issuers with good ESG credentials.

Vanguard USD Emerging Market Government Bond ETF (GBP) (VEMT)

Yield: 5%

This product focuses on bonds issued by emerging market governments. Investors are charged 0.25% a year with Vanguard’s significant scale as an asset manager helping to keep costs low. It provides diverse exposure to bonds with maturities greater than one year.

The magnitude and speed of the fall meant the spread between high yield corporate bonds and government bonds blew-out to 8.7%, a level not seen since the European sovereign debt crisis of 2011.

Higher yields are supposed to compensate investors for the risk of not getting their money back and so tend to spike higher during recessions and market crises. So what, if anything, does the current 6.2% yield say about future default rates?

According to credit analysts at Deutsche Bank the current yield implies that 28.5% of the debts issued by companies in the European high yield bond index are expected to default over the next five years.

To put that into perspective, during the financial crisis of 2008, the default rate in the high yield market was 12%, meaning that today’s prices already reflect a lot of pessimism about the ability of companies to continue paying off their debts.

Bond ETFs provide cheap, diversified exposure

Valuing bonds isn’t something that the typical investor feels comfortable doing, and picking good bond fund managers can be equally tricky, which means for many people getting access to the bond markets is best done through passive bond ETFs (exchange-traded funds).

Investors can achieve diversified exposure to the debts of hundreds of companies, spread across all sectors of the economy, helping to mitigate company-specific risk.

Bond ETFs track particular bond indices and trade like a share in the sense they are continuously priced to reflect the value of the underlying assets in the fund. This feature makes them different to tracker funds, which are usually priced once a day.

Because an index is composed of hundreds of different bonds, some of which trade in minimum size blocks, it can be impractical to fully replicate the basket. Therefore bond ETFs use sampling techniques to build portfolios designed to represent the performance of the underlying index. However, it should be noted that bond ETFs are not as liquid as the underlying index they track.

Falling fees

As more ETF providers have entered the space, fees have come down significantly, so that tracking major equity indices such as the S&P 500 index can cost as little as seven basis points. This means that for every £1,000 of investment the fee is just 70p.

In recent years more providers have started to target the bond market, where passive investing only represents around 15% compared with over 50% for shares. This increased competition is reducing fees in the market for bond ETFs, making it cheaper for investors to get diversified access. 


TWO HIGH YIELD CORPORATE BOND ETFS TO BUY

iShares Global High Yield Corporate Bond GBP Hedged UCITS ETF (GHYS)

Yield to maturity: 6.5%

This £126m fund is managed by BlackRock, one of the biggest providers of ETFs. The fund aims to track the performance of the Markit global developed markets liquid high yield index.

The largest holdings include the debts of Sprint Corporation which is now part of T-Mobile, Ford Motor and Israeli generic pharmaceutical company Teva. 


JPM Global High Yield Corporate Bond Multi-Factor UCITS ETF (JHYP)

This fund is managed by an experienced three-man team at JP Morgan and takes a different approach by applying what they call a multi-factor strategy to security selection. Rather than replicating the whole index, they reduce the universe by screening for companies with good value, quality and momentum.

By taking this extra step the managers believe they can increase diversification, lower volatility and enhance returns, while providing an equivalent yield to the index. Effectively investors are getting some active management for free while the fund is attractively priced at 0.35%.

This is a relatively new product launch and so more cautious investors may want to monitor its performance until it has developed a track record.

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