Calvert News & Commentary

Active High-Yield Management Can Help Smooth Volatility

Passive high-yield ETFs can be significantly more volatile than actively managed high-yield funds.

12/7/2012

By James Lee, Senior High-Yield Analyst, Calvert Investment Management, Inc.

James Lee,
Senior High
Yield Analyst

While exchange-traded funds (ETFs) that passively track high-yield bond indices have become increasingly popular among investors, there are characteristics of the high-yield market that may make high-yield ETFs significantly more volatile than actively managed, open-end high-yield bond funds. Investors who want to add high-yield exposure to their portfolios should be aware of how ETF structures and the high-yield bond market can interact to affect the performance of their holdings.

ETF Volatility in Rallies and Sell-Offs

Unlike most stocks, which have continuously available bid and ask prices posted on exchanges throughout the trading day, high-yield corporate bonds trade over the counter in limited volumes. Some high-yield bond issues may not change hands at all during a particular trading day. As a result of the financial crisis of 2008 to 2009, bond dealers have reduced the amounts of high-yield bonds that they hold in inventory in order to cut back on their own risk, which has caused the difference between the bid price and the ask price on high-yield issues to widen. Investors can visit www.finra.org to use the Financial Industry Regulatory Authority (FINRA)'s Trade Reporting and Compliance Engine (TRACE) to find information on corporate bond trading volumes.

Passive high-yield ETFs are designed to track the broad high-yield market by following some sort of market index. Investors should be aware that during times of market volatility, a high-yield market sell-off can force ETFs to sell large holdings (major components of the indices that they track) at low prices into a market where there are few buyers. By the same token, a rally in a high-yield index can force ETFs to buy bonds in the index at relatively high prices. As a result, high-yield ETFs tend to overshoot the broad high-yield market in both down and up markets. This is the situation that faces a forced buyer or forced seller in any market. In contrast, an actively managed high-yield portfolio has the freedom to use changes in market conditions to its advantage—buying at low prices during a downturn, for example. High-yield ETFs tend to become increasingly volatile in times of market stress, such as the financial crisis of 2008 and 2009, as the broad high-yield market becomes more thinly traded and volatile.

There is another factor that can make high-yield ETFs significantly more volatile than actively managed high-yield funds. Unlike the shares of an open-end mutual fund, which always sell for the proportionate value of the fund's total net assets, ETF shares can fluctuate relative to the value of the underlying assets based on demand. When investors are clamoring for high-yield ETFs (typically when the high-yield market is rallying), shares of those ETFs can sell at a premium to the value of the underlying bonds and other securities. Conversely, when investors are rushing to exit the high-yield market, ETF shares will likely sell at a discount to the value of the underlying bonds and other securities. For the investor, these premiums and discounts compound the inherent volatility of high-yield ETFs caused by the relatively thin trading in the market.

Large Redemptions Distort ETF Prices

Some institutional investors have been exploiting another unique feature of ETFs and creating even more divergence between the performance of high-yield ETFs and the indices that they track. This performance divergence is known as tracking error. Earlier in 2012, institutional holders of some large high-yield ETFs redeemed their shares and received the underlying securities instead of cash. This is a relatively easy way for these large investors to access the high-yield bonds as opposed to trying to buy them in the open market, where the spread between the bid price and the ask price is generally wide. These large ETF withdrawals are not publicly disclosed and can distort the price of the ETF shares in relation to the index that the ETF tracks.

Inadvertent Exposure to Increased Risk

In addition to these pricing issues related to how ETFs and thinly traded markets interact, holders of high-yield ETFs may also be inadvertently taking on more default risk than they realize. Companies with the highest levels of debt outstanding tend to be the largest components of indices that track the high-yield market. Thus, the ETFs that track those indices will hold larger proportions of those bonds. With all other credit-related factors equal, companies with more debt outstanding usually have a higher level of potential default risk than firms with lower levels of indebtedness.

This tendency of high-yield ETFs (or ETFs that track any corporate bond index) to take larger stakes in highly indebted companies relates to a more general drawback of ETFs—they indiscriminately track an index without applying any credit analysis. Although the default rate for U.S. high-yield bonds is currently low by historical standards—the default rate for the 12 months ended October 31 was 2.75% according to Standard & Poor's—it is still significantly higher than the default risk for investment-grade debt. Active credit analysis and portfolio management can help a fund avoid credit problems and defaults.

Active portfolio management does have some drawbacks relative to passive management. Actively managed funds typically have higher fees and expenses than passively managed portfolios and may generate more taxable income. In addition, an actively managed portfolio may be less diversified than a passive fund and could underperform the market. However, at Calvert we believe that our active fixed-income portfolio management strategies can help to mitigate most of these disadvantages.

Active Management Can Help to Curtail Volatility

Investors comparing passive ETFs with actively managed funds for their high-yield allocations should keep in mind some of the unique characteristics of the high-yield bond market. The market's thin trading can cause high-yield ETFs to underperform in sell-offs and outperform in rallies, which can make ETF performance over a full credit cycle significantly more volatile than that of most actively managed funds. Volatile credit market conditions, which have been common in the four to five years since the start of the financial crisis, can exacerbate the return volatility of high-yield ETFs. Actively managed high-yield funds can apply the expertise of their credit analysts and portfolio managers to help sidestep some of this volatility and also attempt to avoid potential credit problems and defaults, particularly in an economic downturn when financial conditions deteriorate.

This commentary represents the opinions of its author as of 12/7/12 and may change based on market and other conditions. The author's opinions are not intended to forecast future events, guarantee future results, or serve as investment advice. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Calvert Investment Management, Inc. nor its information providers are responsible for any damages or losses arising from any use of this information.

Investments in junk bonds (high-yield, high-risk bonds) can involve a substantial risk of loss. Junk bonds are considered to be speculative with respect to the issuer's ability to pay interest and principal. These securities, which are rated below investment grade, have a higher risk of issuer default and are subject to greater price volatility than investment grade bonds, and may be illiquid.

Indices are unmanaged and do not reflect the payment of advisory fees and other expenses associated with an investment in a fund. Investors cannot directly invest in an index.