ETFs That Invest In Junk Bonds. Here's What To Consider

Having cut my teeth with High-Yield (Junk) bonds back in the heyday of the era, when Drexel Burnham and Michael Milken ruled the kingdom from the famous X-shaped Beverly Hills trading floor (with Milken holding down the center point) and annually feted courtiers with what later became dubbed “The Predator’s Ball” (if you haven’t heard of this, do some Googling — it’s an amazing story). I know how those sausages are made and have not been a fan of this asset class. But on scanning the list of Junk Bond ETFs produced by the PortfolioWise screener, I spotted three interesting variations on the theme: ETFs that invest in senior loans. I’m not about to suggest that anybody back up the truck here. But no matter how many times advisers and gurus counsel against yield hogging, the reality is that many will do it anyway (understandably given how low rates still are). If you or your client is, in fact, insisting on junk, at least give these ETFs a good once over.h3 Risk, Risk, More Risk, And Some Return/h3

Obviously, credit risk is present. How much of a problem is less obvious. I gave up looking at default rates back when I was managing a junk bond mutual fund given my sense that published data was junkier than the bonds. It seemed to me that the way default rates were kept at or below 4% was that they (whoever “they” were) stopped counting as soon as the tally for the year reached 4%.

Seriously, there was one year that I knew of and could name enough busted issues to have made up more than 4% of the market. Then, I realized that the default rate was the right answer to the wrong question. Default is a legal event, a missed payment or breached covenant. These, are indeed, rare. That’s because terms get changed (“restructured”) when default seems imminent but before it actually happens — but after the securities have already plunged as far as they would have been had there been an actual default.

Whether or not one wants to count a troubled issue as a full-fledged default, the important thing to understand is that there’s an inherent human bias toward smoothing when it comes to forecasting. Boom times often turn out better than the most optimistic forecasts. Bad times, on the other hand (and this is what we need to be thinking about now) often turn out to be much worse — and it takes only one missed obligation to blow up a junk bond — often irreparably.

And, by the way, nobody really knows what the NAV of any of these funds is. The bonds seldom trade so daily pricing is estimated by outside services hired by portfolio managers. It’s only when you really need to get out of a position that you find out what the real price is — a price established when some other portfolio manager throws out a number in response to getting harangued by traders who keep hammering the buy side with lines like “Come on, everyone has a price. Tell me what it would take for you to pick up some of this stuff. . . please!” (When we want to speak in a. classy manner, we call this “price discovery.”)

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As noted above, when interest rates and yields round to zero or near zero as often as they do today, there are some messages investors are not going to receive no matter how loudly and advisor shouts. So at some point, it becomes a matter bowing to the notion that if somebody is going to get, let’s put it politely and say . . . aggressive, then one can at least try to be sensible-aggressive instead of are-you-kidding-aggressive.

Senior loans are advance commitments of funds typically made to corporations by banks or similar financial institutions. These were exactly the sort of loans I wished I could have purchased back when I ran my mutual fund.

Portfolio average maturities for ETFs that invest in senior loans tend to be in the vicinity of five years. But duration, the much more important indicator of interest-rate risk, is very low, averaging about half a year. That’s because these are floating-rate loans. (A high coupon can reduce duration even on a longer-term maturity because duration factors in the ability of the lender to earn interest on interest, a consideration that becomes more prominent as coupon rise. A floating-rate coupon is as good as you can get in this respect.)

The real kicker, though, is the liquidation priority. In a worst-case scenario, all creditors are not equal. Some have a higher priority, which means no lender in a lower priority level could get a penny until those higher on the hierarchy get paid off. And some creditors even have security interests in physical corporate assets, much like a mortgage on your home. So if there was a need for restructuring, or a bankruptcy (and the creditors’ committee negotiations, that would be part of the process), the senior lenders, those at the top of the hierarchy, would be the ones leading the talks and whose interests would be best protected by any solution that emerged. Holders of the stuff owned by the typical junk-bond fund would be in the shut-up-and-take-what-we-give-you position.

High yield debt is always brutally risky and credit blowups (whether they lead to restructuring or full-on bankruptcy) are very painful 100% of the time. But if I’m going to get hit with one of these situations, I’d sure as heck prefer to be a senior secured lender rather than lower-than-dirt bondholder. (Are equity holders lower than bondholders? In theory yes, but in the real world, management holds equity and always finds a way to take care of itself in the restructuring. Exhibit A: Donald Trump, Exhibit B. Me, who was one of many bondholders burned on his casino debt).

Two of the Senior Loan ETFs I found are ranked Neutral under our Power Rank ETF model, which is as good as it gets now in the high-yield area, where none are ranked Bullish or very Bullish. The third ETF has a Bearish rank.

Fixed Income is an area for which we base our ratings entirely on Technical Analysis due to the absence of US Equity constituents that are amenable to more fundamental modeling.

The high-yield fixed-income sample against which model testing can be done is much more limited, even than the already-small one I used last week to present the outstanding real-money-period results achieved by the model for the Global Thematic ETFs I discussed last week. It’s also noteworthy that for a primarily trend-oriented model such as we use, Global Thematic ETFs posed much less of a challenge than does fixed income, which most observers understand is at or near a generational turning point in what had, for a long time, been a fabulous trend . Even so, the model has, at least, been exceptional so far for US Fixed Income as a whole when it comes to spotlighting ETFs. to avoid.

Table 1: All US Fixed-Income ETFs