When ETFs can’t work miracles

After I wrote last week about the difficulty of finding attractive yields anywhere in the bond market, some readers wondered whether exchange traded funds (ETF) could be a good and cheap way to invest in higher-yielding areas. For example, as well as standard high-yield bond ETFs, there are at least two that specialise in “fallen angels” (bonds from companies than have been downgraded from investment grade to junk, which have in the past subsequently outperformed the market on average): iShares Fallen Angels High Yield Corp Bond (LSE: WING) and VanEck Vectors Global Fallen Angel High Yield Bond (LSE: GFA). Both have a yield to maturity of around 4%, with ongoing charges of 0.5% and 0.4% respectively. 

Funds like this could be interesting for adventurous investors. However, unlike mainstream stock ETFs that have been around for two decades, and established bond ETFs that hold very liquid debt, such as major government bonds, more esoteric bond ETFs are much newer and have not been tested through a full market cycle. There are reasons to be cautious about how they’ll fare. 

Know the risks before you invest

First, bond indices are usually weighted by market capitalisation, which means that they will have more in the borrowers that issue the most debt (who are often riskier). And the creditworthiness of an index (ie, the average credit rating of borrowers) or its sensitivity to interest rates may deteriorate over a market cycle, increasing its risks without investors realising. Second, tracking a bond index is more difficult than tracking stocks. Trading costs for bonds are higher, meaning that rebalancing to reflect changes in the index is more costly. And bond indices often include a large number of securities (one borrower may have several similar bonds in issue), many of which do not trade very often. This means bond trackers often hold a sample of the securities in the index rather than all of them. 

Active managers won’t always manage credit risks better. But investors expect ETFs to remain liquid and transparent even if the underlying assets are not. And in a severe bear market, that might lead to some shocks. Poor sampling choices could mean an ETF performs differently to its index. Or poor liquidity in the underlying bonds might make it harder to keep an ETF’s share price in line with the value of its assets (which, briefly put, involves major investors trading the underlying assets directly with the ETF issuer). This won’t necessarily be a problem – but we won’t know until these new ETFs have been through a severe downturn. So if you’re tempted to invest, tread cautiously for now.