Thursday, March 29, 2012

Junk ETFs

By Tim Dulaney, PhD

The Wall Street Journal ran a great piece earlier this month concerning Junk ETFs.  For another recent prospective, see the recent blog post by Michael Aneiro.  We have discussed exchange traded funds (ETFs) a great deal on this blog, but we haven't yet addressed the issue of Junk ETFs.  A Junk ETF is an ETF that invests in high-yield bonds in an effort to garner high returns.  Of course high-yield is just an industry euphemism for low-quality (or high-risk) since, generally speaking, investors demand higher yields on fixed-income securities when the quality is low.  For a list of Junk ETFs, see here.

It is not surprising that investors are turning to junk bonds -- or funds that invest in junk bonds --  as a result of the low interest rate environment in which we find ourselves.  Investors are searching for yield any way they can find it and as a result are taking on more risk by investing in these lower-quality bonds.  In fact, the WSJ article reports that
[s]o far this year, mutual funds and exchange-traded funds investing in high-yield, or "junk," bonds have taken in more than $17 billion in new money. Roughly 15 cents of every dollar flowing into all stock and bond funds combined has gone into junk alone.
Of course, investors should realize that as demand for these high-yield bonds increases, the prices on the bonds go up and therefore the yield on the bonds decreases.  Junk ETFs are also much more liquid than the high-yield bonds the Junk ETFs hold.  As a result, Junk ETF investors pay "[...] around a 0.6% premium to the value of their assets [...]".   This liquidity premium is only one of the issues investors should consider before investing in Junk ETFs.

Another issue outlined in the article is that the prices of the underlying securities are inflated by approximately 0.6% relative to similar high-yield debt basically as a result of the ETF's investment in those securities.  The pricing premium, liquidity premium and fees can significantly decrease the realizable yield of Junk ETFs.

Of course, Junk ETFs also have some benefits that investors should consider.  Investing in a Junk ETF could be less risky than investing in a single high-yield bond since the ETF invests in many high-yield bonds and therefore realizes a diversification benefit in their return volatility.   Similar to many other types of ETFs, Junk ETFs also offer retail investors a way to gain exposure to high-yield debt when direct investment might be unfeasible.  The stock-like characteristics of Junk ETFs also offer investors an easier way to decrease exposure to high-yield debt than would an analogous direct investment in junk bonds.

Obviously every investor should consider their own needs, goals and expectations for the future before making any investment decision.  We hope this short post has shed a little light on this segment of the ETF market.

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