Wealth Manager

And one that’s been a long time coming. Barclays first sought
regulatory approval for the security in the summer of 2003.
Nearly four years later, the shares finally started trading. What
took so long? “Because this is the first ETF offering exposure to
the high- yield market, there was a greater level of scrutiny than
there might be for other products,” says Matthew Tucker, head of
investment solutions at Barclays Global Investors.

The ETF is the first junk bond index fund of any kind in the
U.S. market. Even among the dozens of mutual funds plying the
lower-grade debt market, no publicly traded portfolio formally
tracks an index. As such, the new iBoxx ETF fills a long-running
hole for the indexing of a major asset class.

As indexing migrates into more exotic corners of the capital
markets, the subject of passive management is debated anew.
Hedge fund and managed futures strategies, for instance, are
now being indexed by some ambitious shops.

If passive management can be applied to alternative investing,
surely junk bonds can be indexed. In theory, yes. In practice, it’s
a bit messy.

The new iBoxx ETF is effectively an experiment that can only
be judged over time, along with other efforts to bring indexing
to areas of finance that have formerly been the domain of active
management. Clearly, the market for high-yield bonds poses one
of the bigger challenges to date for ETFs. Bonds rated less-thaninvestment
grade—below the BBB credit rank but not in default—
are still debt securities, of course. But there end any similarities
with Treasuries and investment-grade corporates.

The distinction is a source for both additional return and risk.
Finding a happy medium is an untested challenge for junk bond
indexing. There are two main incentives to try. One, high yield
offers higher expected returns over the long haul relative to investment-
grade bonds. Two, the asset class tends to move independently
of higher-grade debt and other asset classes, thereby
offering a diversification bonus.

Consider the low correlation that junk bonds have relative to
the investment-grade world. For the five years through this past
March 31, the Credit Suisse High Yield Index posted a correlation
of only 0.18 with the Lehman Brothers Aggregate Bond Index,
a broad measure of investment-grade U.S. bonds. (1.0 is perfect
positive correlation, 0.0 is no correlation.) Junk bonds also offer
diversification benefits relative to stocks. During the five years
through March, CS High Yield’s correlation with the S&P 500 was
a modest 0.51.

But wait—there’s more. The case for a strategic holding of highyield
bonds becomes even stronger when you compare the asset
class’s correlations to other asset classes, including REITs, commodities
and foreign stocks (see table below). What’s more,
junk’s performance has been competitive.

History, in short, suggests that high-yield bonds are worth
owning. Unfortunately, the history is drawn from an index
that—while widely cited and respected—isn’t investable per se.
That should give thoughtful investors pause because high-yield
bonds are relatively illiquid. Although some debt in this realm
trades with a degree of frequency, much of it lies dormant for
days, weeks or longer.

The point is that CS High Yield and other benchmarks that
are familiar in the institutional world are hard to trade when it
comes to satisfying the minute-by-minute, tick-by-tick liquidity
that’s standard for running ETFs. The mechanics of the listed
funds include their so-called creation and redemption feature.
New shares are created and liquidated upon demand. That serves
to immunize an ETF from the closed-end fund disease: Deviating
too far from the underlying net asset value. Meanwhile, maintaining
ETF liquidity, a key selling point, means that the market
makers must be able to hedge themselves quickly and efficiently
when new money flows in or out. The contingency demands a
liquid index underlying the ETF.

Considering the hurdle, what can investors expect from the
first high-yield bond index fund? A bit less than junk bond indices
might suggest. Consider how the iBoxx $ High Yield Corporate
Index (the benchmark for the new ETF) compares with Credit
Suisse High Yield. For the eight years through this past March,
for instance, the iBoxx benchmark’s 4.7 percent annualized total
return trails CS High Yield’s 7.4 percent by more than a little. The
disparity narrows for the last three years through March, but
iBoxx still lags CS High Yield by over 100 basis points a year.

Why the difference? In essence, that’s the price for moving
from a non-investable index to one that is investable. “One of
the real challenges with the high-yield market is that a lot of
the indices aren’t investable,” says Tucker. “They often contain
1,000, maybe 1,500 securities. At any given time, a few hundred
of those bonds might actually trade in the market. But the rest
really aren’t available to investors.”

CS High Yield is a broad measure of the high-yield universe,
holding more than 1,000 securities that encompass a diverse
mix across the spectrum of lower-grade credit risk. Some of the
bonds in CS High Yield may even be close to default. In sharp
contrast, the iBoxx index holds only 50 bonds—50 securities that
are among the most liquid junk bonds, which generally means
relatively higher-rated securities.

By focusing on higher-rated bonds with higher liquidity, the
iBoxx index may sacrifice some expected return relative to the
non-investable indices that claim a broader universe. Add to that
the 50-basis-point expense ratio charged by Barclays iBoxx $ High
Yield Corporate Bond ETF.

The price tag associated with going investable is hardly a surprise.
Lower risk tends to translate into lower returns. It’s true
for equities and investment-grade bonds, and it prevails in highyield
securities, too.

But there’s no mystery as to why: “Triple-C bonds default at a
higher rate the single-Bs; single-Bs default at a higher rate than
double-Bs,” says Martin Fridson, president of FridsonVision LLC,
a New York research shop focused on high-yield bonds.

In exchange for the higher default rate, investors demand higher
returns. A diversified portfolio of high-yield bonds that holds more
lower-rated securities has a higher expected return, albeit with
higher risk. Modern portfolio theory teaches no less, and recent
history seems to confirm it. For example, for the year through the
end of this past March, the BB-rated bonds in the Citigroup High
Yield Index posted a 9.3 percent return. The CCC-rated bonds in the
same index rose by more than twice as much: 19.4 percent over the
same 12 months. Of course, when the market turns, the opposite
will likely be true as well—namely, bigger losses for bigger risks.

Barclays didn’t have much of a choice other than to use an
index like the iBoxx benchmark, which targets the more liquid issues.
Barclays’ Tucker notes that the iBoxx $ High Yield Corporate
Index has a “built-in liquidity screen.”

The Frankfurt, Germany-based International Index Co. (IIC)
maintains the iBoxx index. At the end of each month, IIC rebalances,
favoring the 50 most liquid bonds, each with a roughly
2 percent weighting.

That raises another question: Are 50 bonds enough to maintain
a diversified, representative portfolio in a varied universe
of debt with thousands of issues? Barclays thinks so. Tucker
says that the index holds securities from different industries to
avoid concentration in any one corner of the economy. On top
of that, the most liquid securities are chosen to represent each
industry. Bottom line: The iBoxx is designed to be a liquid measure
that reflects the broader high-yield universe, with weights
in industries that roughly approximate the weightings in the
overall marketplace.

Still, some observers are skeptical. Sonya Morris, editor of
Morningstar’s ETFInvestor newsletter, says the new high-yield
ETF “isn’t very diversified.” She also opines that the relative inefficiency
in the junk bond market gives active managers an edge
over passive strategies.

In fact, of the 117 high-yield mutual funds with track records of
five years or more through the end of this past March, the range of
annualized five-year total returns ranged from a high of 16.2 percent
down to 4.7 percent. The iBoxx index fares near the low end of
that range, posting a 6.3 percent annualized return.

On the other hand, there’s no doubt that the iBoxx
index has captured a large chunk of the market profile
for high-yield bonds, albeit with lesser performance.
The correlation of monthly returns between iBoxx and
CS High Yield is a high 0.89, based on monthly total
returns from January 1999 through this past March.

While investors may wonder what’s held in the CS
High Yield and other benchmarks, Barclays should be
applauded for bringing a high degree of transparency
to its junk bond ETF. All 50 bonds, including weights,
yields and other information, are published at the end
of each trading day on iShares.com.

Whatever the caveats, wealth managers are intrigued
by the first high-yield index fund. “I wouldn’t be afraid
of using it,” says Matt Forester, a portfolio manager at
Cumberland Investors, a Vineland, N.J. firm that manages money
for high-net-worth clients.

Herb Morgan, chief investment officer of ETFAccount.com, is
watching the new fund as well, although he’s in no rush to buy, noting
that he first wants to see trading depth. “I really hope the liquidity
comes [with the ETF] because high yield’s a great asset class.”

The biggest obstacle may be the asset class itself, which has
been in a bull market for several years. As a result, some are
wary of junk’s prospects for the foreseeable future. One reason
is the shrinking yield premium. For example, iBoxx’s trailing 12-
month yield was 7.5 percent at the end of March, or about 290
basis points over the 10-year Treasury yield. That’s down from
a nearly 900-basis-point spread over the 10-year at one point in
August 2002.

In other words, the timing issue related to high-yield bond
investing worries many wealth managers. There are some things
that even financial engineering and innovation on Wall Street
can’t conquer.