High Yield Bonds Call for an Active Investing Approach. Here’s Why.

• For high yield bond investors, we believe active management offers clear potential benefits due to the composition and structure of the market, which presents specific opportunities that passive strategies will miss – along with challenges that passive strategies may not address or can even exacerbate.

• Over trailing one-, three-, five-, and 10-year periods, the active eVestment universe outperformed ETFs in the Morningstar US High Yield Bond ETF Category at nearly all breakpoints, with rare exceptions, in terms of both total returns and Sharpe ratios.1

• Credit risk is often mispriced, in our view – and we believe in-depth analysis of all industries and issuers can yield a portfolio that may outpace the broader high yield market.

The debate between active and passive management in fixed income presents a compelling study of how the challenges and opportunities facing specific asset classes make the question anything but straightforward. Yet for high yield bonds, we believe active management offers benefits that make it the clear choice over passive strategies.

Passive investment strategies have been gaining more and more market share in recent years. This is particularly true in equities, where data from Nasdaq eVestment show that passive US equity strategies accounted for roughly 56% of total US equity institutional assets under management at the end of 2023; this compares with just 15% for US fixed income as a whole, with the majority in investment grade strategies.2

Yet the suitability of passive investing in asset classes such as high yield bonds remains questionable due to the composition and structure of the market, which present specific opportunities that passive strategies will miss – and challenges that passive strategies may not address, or can even exacerbate.

Challenges of passive investing in high yield bonds

The complexities of the high yield bond market and certain characteristics of the asset class present distinct challenges for passive investing. Unlike equities, in which a company typically issues only one share class that trades frequently, with a relatively narrow bid-offer spread on the public exchanges, high yield bonds are traded over-the-counter, less frequently, and with higher bid-offer spreads. Moreover, the median issue in the high yield market is roughly $500 million (compared to $34 billion for the S&P 500),3 and companies will often issue multiple securities with varying coupons, maturities, and rankings within the issuer’s capital structure.

As a result, the liquidity and trading dynamics in the high yield market make it difficult to arbitrage discrepancies between the price of passive vehicles and the market value of underlying bonds. Exchange-traded funds (ETFs) are the most popular choice for a passive investment vehicle due to their enhanced liquidity and tax efficiency. Exchange-traded funds trade daily like individual stocks. However, ETF investors do not directly participate in the creation and redemption of ETF shares. Instead, these processes occur first in the primary market between ETF providers and specialized financial institutions known as authorized participants, or APs.

Authorized participants create new shares by purchasing a basket of the ETF's underlying securities and exchanging them for a block of new shares from the ETF sponsor. The opposite occurs when APs redeem shares by exchanging the shares with the ETF sponsor then selling the underlying securities. ETF shares trade on exchanges daily and will deviate from their net asset value (NAV) depending on supply/demand conditions. This creates an incentive for APs to engage in arbitrage by creating ETF shares when the ETF is trading at a premium and redeeming ETF shares when the ETF is trading at a discount.

The profitability of these arbitrage trades will hinge largely on the liquidity of the underlying holdings. US large-cap equity ETFs typically do not deviate too much from their NAV, as it would be relatively easy for APs to trade into or out of a basket of underlying securities and arbitrage the difference by creating or redeeming ETF shares. However, trading costs are higher for high yield bonds. According to Bank of America data, the effective bid-ask spread for the high yield market overall was averaging roughly 35 basis points at the end of 2023.4 As a result of lower liquidity and higher bid-offer costs, high yield ETFs tend to trade at premiums or discounts that are relatively high compared to other, more liquid asset classes. This adds an element of risk to investors purchasing or selling shares in an ETF, as they do not have certainty on the potential direction and magnitude of the premium or discount.

Minimal savings on management fees

Another consideration are the fee savings for ETFs relative to actively managed strategies. In large cap equity strategies, an investor may have a lot to gain in terms of fee savings if they opt for a passively managed ETF over an actively managed strategy. The lowest-quartile breakpoint for net expense ratios in the Morningstar US Large Cap Blend ETF category was 15 basis points, while the fifth percentile breakpoint was just 5 basis points. Fees for a $100 million separately managed account in the eVestment Large Cap Core Peer Group were 50 basis points at the median, 40 basis points for the bottom quartile breakpoint, and 24 basis points for the fifth percentile breakpoint. This compares with 35 basis points for the lowest quartile breakpoint and 17 basis points for the fifth percentile breakpoint in the Morningstar US High Yield ETF category.5

Investing in high yield requires a certain level of knowledge, experience, and staffing to successfully trade in the over-the-counter market. Moreover, AUM capacity is not unlimited in this asset class, as it virtually is for large cap equity ETFs. It would not be possible for a high yield bond ETF to grow to the size of the largest S&P 500 ETFs, which can exceed $400 billion, given that the entire high yield market totals about $1.3 trillion. For these reasons, it is not possible for high yield ETF sponsors to gain the same benefit of scale as for equity ETFs, and as a result, average expense ratios are higher.

Fixed Income ETFs Do Not Gain the Benefits of Scale Enjoyed by Equities

Median fee savings

Source: Separate account fee schedule is eVestment alliance as of 31 December 2023. ETF fee schedule is Morningstar as of 29 February 2024. US Large Cap Core Equity savings are the difference between the Morningstar US Large Cap Blend ETF Category Prospectus Net Expense Ratio and the eVestment US Large Cap Core Fee for $100mm Separately Managed Account; US High Yield Fixed Income savings are the difference between the Morningstar US High Yield ETF Category Prospectus Net Expense Ratio and the eVestment US Large Cap Core Fee for $100mm Separately Managed Account.

Tapping the benefit of inefficiently priced risk

Unlike large cap US equities, high yield issuers are typically private, and if they have equity that is publicly traded, it is generally small to midsized in terms of market capitalization. As a result, we believe credit risk is often mispriced – and that in-depth analysis of all industries and issuers can yield a portfolio that may outpace the broader high yield market. Our goal is thus to uncover alpha opportunities and pricing inefficiencies across an issuer’s capital structure. We favor a nimble and dynamic approach that can transition as the credit cycle and macro environments shift.

After-fee performance: the true test

At the end of the day, the most important consideration is performance. Would an investor be better off selecting a passively managed ETF or an actively managed strategy, after fees, in terms of total returns and risk-adjusted returns? For this comparison, we looked at the trailing total returns and Sharpe ratios (net of fees) for the universe of ETFs in the Morningstar US High Yield Bond ETF Category and compared those results relative to the eVestment US High Yield Bond universe at each quartile as well as the top and bottom fifth and 95th percentiles. We calculated ETF returns using the market convention return (not the NAV return), as we viewed this as representative of what an investor would receive if they were to sell their ETF shares in the secondary market. Over trailing one-, three-, five-, and 10-year periods, the eVestment universe outperformed at nearly all breakpoints, with rare exceptions, in terms of both total returns and Sharpe ratios.

Active High Yield Managers Outperformed ETFs in Nearly All Periods

Median active vs. passive outperformance

Median Sharpe ratio performance gap

Source: eVestment Alliance, Morningstar Direct as of 31 December 2023. eVestment US High Yield Fixed Income versus Morningstar US High Yield Bond ETF Category. The median represents the median net-of-fee return and Sharpe ratio from the existing high yield peer group. For illustrative purposes only. Past performance is not indicative of future results.

One could argue that the ETF category contains a variety of strategies with investment objectives and benchmarks that are targeting different segments of the high yield market in terms of credit quality, maturity, duration, or other characteristics. This is a fair point, so we also looked at only the three largest ETFs, all of which have a high yield index as their prospectus benchmark that targets the high yield market generally. Similarly, the median eVestment manager still outperformed on a net-of-fee basis relative to all three of the largest ETFs for most trailing time periods in terms of both total returns and Sharpe ratios.

The Median Active High Yield Manager Outperformed the Three Largest ETFs in Most Periods

Return performance vs. the three largest ETFs

Sharpe ratio performance vs. the three largest ETFs

Source: ETF data is from Morningstar Direct as of 31 December 2023. Net-of-fee composite data is from eVestment as of 31 December 2023. Any references to specific securities are for illustrative purposes and are not to be considered recommendations. Past performance is not indicative of future results.

It can also be said that the ETF category contains a variety of strategies with investment objectives and benchmarks that are targeting different segments of the high yield market in terms of credit quality, maturity, duration, or other characteristics. To address this point, we again focused only on the three largest ETFs and found once more that the median eVestment manager outperformed on a net-of-fee basis for most trailing time periods in terms of both total returns and Sharpe ratio.

The iShares Broad USD High Yield Corp Bd ETF (Ticker: USHY), launched in late 2017, is a relatively new entrant to the high yield ETF space and is relatively cheap, with a net expense ratio of only 8 basis points. This ETF has historically tracked the broad high yield market better than most in the Morningstar US High Yield Bond Category, and not surprisingly, it has seen massive inflows totaling $12.3 billion over the past five years – roughly 40% of US high yield ETF fund flows overall.6

Nonetheless, investors in this fund are not immune to the challenges of investing passively in the high yield market. The premium or discount to NAV can get whipsawed during volatile markets, often exacerbated by a concomitant decrease in liquidity for the underlying high yield securities. In fact, the absolute value of the monthly market returns of shares in this ETF have deviated from the underlying index by an average of 25 basis points per month since inception. This can pose a risk for institutional investors when timing an entry or exit into or out of the fund. This is not the case for an active strategy, which would typically be offered in a separately managed account, commingled vehicle, or an open-ended fund that is purchased and sold at NAV.

Active high yield managers are positioned for outperformance

We believe active management offers distinct advantages when investing in high yield bonds. Inefficiently priced credit risk and the over-the-counter market structure have benefited active investors, which have historically recorded superior risk-adjusted returns compared with passive strategies. Asset managers with deep and broad credit research teams and capabilities, that focus on bottom-up security analysis and selection, may be best positioned to tap the benefits of price discrepancies.

In periods when default rates, volatility, and correlations increase, these dynamics create more technically driven markets, given that risks dominate the idiosyncratic factors that allow for positive contribution via credit selection. In these environments, an active approach may help high yield strategies to perform near benchmark levels. Conversely, as market dynamics turn favorable and credit spreads tighten, we believe a bottom-up, research-driven approach can better identify opportunities before others in the market catch on – providing a compelling advantage to investors.