High-yield bond ETFs hit by big outflows this year

Investors yanked money out of U.S.-listed high-yield bond exchange-traded funds during the first nine months of this year, but the Wyoming Retirement System apparently liked one of them enough to invest $60 million in it.

Sam Masoudi, chief investment officer of the roughly $10 billion pension system, disclosed the investment in the iShares iBoxx $ High Yield Corporate Bond ETF, a passively managed ETF from New York-based BlackRock Inc., in a September email to Pensions & Investments.

The ETF, which had $12.8 billion in net assets as of Oct. 25 and ranks as the biggest ETF in Chicago-based Morningstar Inc.'s high-yield bond category, had $6.4 billion of net outflows this year through Sept. 30, according to Morningstar.

And it's far from the only one to leak cash. ETFs in Morningstar's high-yield bond category had net outflows totaling $16.9 billion this year through Sept. 30. That's noteworthy, said Bryan Armour, Chicago-based director of passive strategies research for North America at Morningstar Research Services LLC, a Morningstar subsidiary, given that the combined net assets of those ETFs totaled $54.7 billion as of that date.

Those high-yield bond ETFs invest primarily in lower quality U.S. dollar-denominated corporate bonds, Mr. Armour said. High-yield bonds are often the first securities to be jettisoned from portfolios when recession fears take hold, he said.

"When the economy falters, there's a higher risk of default, especially for the riskiest borrowers," said Mr. Armour, who also cited the impact of recent Federal Reserve rate hikes. When interest rates go up, "it can really increase the cost of capital for these borrowers," he said.

While calls and emails to Mr. Masoudi and others at the Cheyenne-based pension system failed to elicit comment regarding its iShares iBoxx $ High Yield Corporate Bond ETF investment, others said they believe high-yield bonds, even with a potential U.S. recession looming, can offer opportunity for investors.

"We have a lot of conviction that now is a good time to invest in high yield, particularly short-duration high yield," said James Barrineau, New York-based chief investment strategist at Main Street Financial Group, a financial advisory firm, who cited several reasons behind that conviction.

"First, default rates should remain low," Mr. Barrineau said, adding that large segments of the high-yield market are in industries such as energy and industrials that tend to be less impacted by stressed consumers.

"Second, the low dollar price on these bonds protects your downside and lowers volatility for this part of your portfolio," he said, adding that the average bond price for high-yield bonds in the one-to-five-year maturity range is about 89 cents on the dollar.

"So, the fact that you're fairly close to maturity and the bond price is already significantly below par really protects your downside," he said.

Short-duration high-yield bonds also offer the opportunity to "pick up considerable yield vs. investment-grade bonds that are shorter in duration," he said, adding in an Oct. 24 interview that short-duration investment-grade corporate bonds currently offer about 300 to 400 basis points less in yield.

"Lastly, other fixed-income alternatives that generate good yield either come with lots of duration risk, like (mortgage-backed securities) or much higher credit risk like emerging markets," he said.

Main Street Financial Group, which Mr. Barrineau said doesn't disclose its assets under management, uses both ETFs and individual bonds when seeking high-yield exposure for its clients.

"We like SJNK because it goes out to five years," he said, referring to the SPDR Bloomberg Short Term High Yield Bond ETF by its ticker symbol. "A lot of the short-duration high-yield bond ETFs have a maximum maturity of three years, and the yield is considerably compressed."

Matt Camuso, ETF strategist at BNY Mellon Investment Management, said high-yield bond spreads have widened to levels that present an attractive opportunity for investors, albeit one that requires a cautious approach.

"It's still a risky part of the market," Mr. Camuso said, adding, however, that for investors who have completely abandoned high yield, "now is the time to at least look back at the asset class and say, relative to history, at the yield levels we're at, it's time for more of a strategic allocation to high yield as part of your broader fixed-income solution."

The strategist cited an Aug. 3 report from Insight Investment, an investment affiliate of BNY Mellon Investment Management.

"Rate hikes, inflation and economic concerns have caused high yield markets to reprice sharply," the report said. "Given bottom-up fundamentals, we believe the income potential is becoming harder to ignore."

While the economic outlook is worsening, corporate balance sheets "are starting from a position of strength," leaving space for corporate credit strength to decline before distress sets in, according to the report titled "Is it time to consider high yield?"

Nearly 60% of bonds in the Bloomberg U.S. Corporate High Yield index were issued in 2020 and 2021 as companies during the COVID-19 pandemic rushed to raise liquidity and lock in lower fixed rates for longer to ride out the uncertainty.

"This has dramatically reduced and delayed corporate refinancing needs," the report said, adding that high-yield issuance was down about 70% year-to-date in 2022, "indicating that the corporates have less need to come to market." At 0.1%, the 2021 high-yield default rate was well below the historical average of about 1.5% over the 17-year period starting with 2005, Mr. Camuso said, adding default rates will likely increase if the economy hits tougher times.

"But even if we got to the average of a percent and a half, given where yields are now at over 9%, you still have that really healthy income component to offset that average default," the strategist said, adding that even if the default rate were to reach an extreme — such as the 5.3% level it hit in 2009 — "you're still getting a yield that potentially exceeds that of BBB credit."

BNY Mellon IM had some $1.9 trillion in assets under management as of June 30. Its ETFs include the $49.8 million BNY Mellon High Yield Beta ETF, introduced in April 2020. That ETF has seen $9 million of net inflows this year through Sept. 30, Mr. Armour said.

A BlackRock spokesman declined to comment regarding the outflows from the iShares iBoxx $ High Yield Corporate Bond ETF as determined by Morningstar. He emphasized, however, that institutional investors use the ETF in ways that go beyond just buy-and-hold investments.

In comments provided via the spokesman, Carolyn Weinberg, a managing director and global head of product for ETF and index investments at BlackRock, said demand to use the ETF is higher than ever amid the most volatile markets in years.

"HYG has seen several all-time highs for daily trading volumes during 2022, a surging options market and is now one of the most actively traded securities on all of NYSE," Ms. Weinberg said, referring to the ETF by its ticker symbol. "Whether through direct holdings or derivative exposures to HYG, the ETF has become the vehicle of choice for expressing views on this segment of fixed income."

Reporter Rob Kozlowski contributed to this story.